17th January 2016 by Chris Iggo
Volatility has certainly increased and with it the range of expectations about how the world economy will evolve this year has expanded. Some call for recession and financial crisis, others say it’s not so bad and the Federal Reserve (Fed) will stick with its rate normalisation programme. One thing is for sure, financial assets are, generally, getting cheaper. Not that I get a sense that anyone is really itching to buy. But that will come. January doesn’t last forever.
The man (men) who sold the world – There was one overwhelmingly negative piece of news this week. But more about Bowie later. Compared to the transcendental importance of “A Space Oddity” or “Heroes” the volatility of financial markets is incidental. But of course we can’t ignore it even if the only reason is that great art needs wealth creation to allow it to bloom and flourish. In reality there are more reasons – the markets are the barometer of economic health. They are where we store our savings, where many of us make a living and where great ideas for the advancement of economic well-being are financed. And this week the message is that there is something seriously going wrong with the global economy. With the increased volatility and the rapid erosion of billions of dollars of paper wealth comes the commentary of impending catastrophe, famine and plague. This ain’t rock ‘n’ roll, this is genocide. The S&P500 is down 6% already this year, some European markets are down by 7%-9% and Asia is a disaster. Investment grade credit spreads are 10bp wider while high yield in the US has delivered a -2% total return already, pushing the average yield on the index above 9%.
Life on Mars – I remember touring the UK in 2008 with my boss at the time, Theo Zemek. With Lehman gone and other financial institutions on the brink, we had lunch with some financial advisors and wealth managers at Rudding Park, just outside Harrogate. The mood was not good. People were worried about what the economic landscape would be like after the crisis, with the banking system on its knees and governments having taken on masses of debt. Theo, in her own way, said “look, when this is all over you will walk through Harrogate or York and there will be banks, shops, bars and restaurants. Life will not stop. Some businesses may fail but growth will resume and there will be ways to make money again”. With hindsight it was such an obvious message but when investors were redeeming assets at losses and the economy was heading into a deep recession it was not the easiest picture to paint. Is today as bad for the developed economies? Are our financial institutions failing? Is the economy going to contract by several percentage points in the next two years? The answer is no. We will still need oil and copper. Emerging economies are not in as bad a state as they were when glam rock was all the rage. There will be ways to make money again. One interesting observation from the markets this year is that Treasury and other core yields have not fallen that much. There has been something of a flight to quality but fixed income yields are so low already that bonds don’t provide much of a hedge for risky assets any more. Another way of looking at that might be that there is no signal from rates markets of impending recession. If the US economy continues to generate more than 250,000 jobs per month then we can be somewhat optimistic on that front. Global manufacturing might be in recession, but the broader picture in the developed world is not that bad.
Ashes to Ashes – Today the issue is that we are coming out of a long period of financial asset price inflation that was mostly driven by monetary policy. Financial prices reached levels that can only be justified if inflation remains absent, interest rates remain low and corporate earnings growth remains strong. Any deviation from the perfect leads to price adjustments. So Fed normalisation and the negative growth impact of the great Chinese transition have a significant impact on equity prices and credit risk. Stock valuations and credit spreads have been based on expectations of corporate revenue growth that are not consistent with the post crisis rate of growth, especially when we are not seeing the additional boost to growth that was generated by leverage in the last cycle. This has been most extreme in sectors where unit prices have fallen the most – commodities. The contagion is natural. Contagion breeds forecasts of financial disaster which verge on the disrespectful to the many that feel humbled and stupid by the suggestion that they should have been hoarding corned beef and bottled water rather than trying to grow their savings and provide for their families’ futures.
Let’s Dance – The lessons of 2008 and 2012 were to seek the value opportunity. It was to identify where credit spreads were too wide or where the system would not let a company or country go bust. Money was made in the recovery. It will be again. I doubt all mining companies are going bust. There are distressed assets that will recover. Moreover, there are parts of the economy that should benefit from these extremely low oil prices. The bears always argue that higher oil prices are a tax on growth but they’ve been very quiet about the massive tax cut that all global energy consumers have experienced over the last year or so. Is it better that economic rent from high oil prices benefits a few producers than the bigger and broader number of economic agents that benefit from lower energy costs and, by extension, more disposable income? If consumers are spending hundreds of dollars less on gasoline imagine how tempted they might be to buy the iPhone 7. Just saying.
Sorrow – I’ve been visiting private bankers in Switzerland this week. Keep in mind that the benchmark there for the last year has been cash with negative interest rates, so euro credit yielding between 1% and 2% is reasonably attractive. The more adventurous are looking to high yield and emerging markets again. A strong message was that they are going back to beta strategies because of a general disappointment with absolute return that has mostly failed to beat simple bond benchmarks. This illustrates the faddishness of the investment world. People wanted absolute return strategies when yields were falling to the bottom. After a considerable time of yields being at the bottom it has become clear that you can’t magically conjure up returns. The lesson is also that in bonds, mostly, in a world of depressed yields where market returns are low and interest rates are not really going anywhere, absolute return strategies, at best, can only deliver capital protection. In bonds they can’t give you significantly above market returns unless the strategy includes a lot of leverage, heavy use of derivatives or non-bond alpha sources like FX.
China girl – Who knows where this volatility will end. As I said last week we normally look to policy makers to turn things around, but it is not clear today how that might happen without a very clear signal from the Chinese government on how it will manage the risk of a hard landing. In the meantime I would sit tight, focus on short duration credit strategies, have some long-term inflation protection and look for opportunities to get back into high yield in the US and commodity related sectors. For UK investors it seems that Mark Carney wants to serve his entire term without raising interest rates so short duration sterling credit is a nice safe option given where UK credit spreads are. The short end of the UK investment grade yields is close to 2.5% and a nice alternative to cash for those investors not ready to head back into riskier parts of the market. In equities the sell-off is pushing up earnings and dividend yields so raising the attractiveness of the asset class once the macro picture improves. Forward price-to-earnings ratios are still somewhat elevated and likely to stay so as earnings growth forecasts are revised lower, but there will be value emerging in many sectors. One also has to be encouraged by some other market developments this week – especially the massive demand for the jumbo bond issue in the global beverages sector this week. Some $46bn was raised against total demand of $117bn for a series of bonds that are being issued to finance a big takeover. Investors want quality assets still, and people will always drink beer.
Heroes – So in summary I would stick to the view that the growth outlook in the developed markets is still positive, albeit modest, and that the key marginal factor in global growth is China. Sentiment towards China is extremely poor. It may improve if the Chinese announce some policy initiatives, or if there is some stronger data, or if it becomes obvious that oil prices are finding some floor. For bond markets we think credit spreads are starting to price in too much bad news and that some sectors will provide some recovery opportunities at some point. In the meantime, short duration strategies in credit remain the low-risk way to play the bond market.
Starman – Born in the early ’60s to parents that used to enter jive competitions at Sheffield City Hall to the sound of Bill Haley and Gene Vincent, popular music has been a constant and tremendously important part of the tapestry of my life. As it is to my children now. Bowie was my musical journey entry point. When the UK was plunged into darkness in the ‘70s (now that was a real oil crisis) I was painting Aladdin Sane stripes on my face and wearing out the vinyl on my Diamond Dogs LP. So much has been said this week but for me the most poignant expression of emotion was in Brixton with the impromptu tribute to David Bowie’s life. All ages, all colours, all creeds. Bowie brought colour, drama, expression, creativity, great tunes and fun into a world that is more often than not grey, humourless, cold and viscous. Faced with an uncertain and difficult world we should remember one of his lyrics at least – “we could be heroes, just for one day”.