Markets have started 2016 weakly – a surprise to many investors, who now find themselves seeking answers about why this has happened and when, or if, it may stop.
Many of the articles that we have read make very good points about Chinese growth or devaluation, or US monetary policy, the value of the US dollar, equity valuations, oversupply of commodities and so on.
The problem is these were, in the large part, used as explanatory factors for the August 2015 sell-off, but then there was a strong rally in most assets before this latest bout of weakness. Could it happen again?
Our response is to review the available evidence and try to draw reasonable conclusions, so let’s go through that.
Firstly, an economic assessment. An inconvenient truth for the bears’ case may be that western economies look like they are in pretty good shape, with moderate levels of growth, relatively low inflation and evidence of labour markets finally tightening enough to allow some wage growth. This assessment appears in tune with the US Federal Reserve, which made its first interest rate rise in almost a decade in December.
An assessment of emerging market and commodity-biased economies would be far less benign, particularly in countries such as Brazil, but the bearish narrative is principally focused on China.
Here the picture remains obscured by suspicion about the quality of economic data produced. As a result, many choose to follow the Li KeQiang index, which is flagging economic weakness in ‘industrial’ China but does not capture service growth – so again, an imperfect metric.
In our discussions with fund managers there is little agreement about what is going on, with some promoting the idea of China weakness creating global systemic issues (deflation), while others suggest that economic reforms and stimulative policies could cause a near-term pick-up in the economy.
China is the great unknown for the time being – something that should be concerning, as it is too important to the functioning of the global economy.
The nature of US valuations has been worrying us for a while now. It is no longer a small selection of stocks that is overpriced, as was the case in 2000 with technology-related shares.
Our research suggests the average US stock now looks pretty fully valued, which means there needs to be an upswing in profits to support such a level, let alone drive higher returns. This seems unlikely, so we remain underweight this market.
The Schroder Diversity range of funds has been running with a cautious positioning for a while now, using higher than average levels of cash to protect in volatile periods such as we are currently experiencing.
This has been very helpful in insulating our investors from the full force of the recent sell-off, but the question inevitably is, “when will it be time to start bargain hunting?”
As ever, this is a tricky question to answer, but some valuations are becoming attractive.
Marcus Brookes is head of multi-manager at Schroders