‘Cautious optimism on US stocks is sensible base case’

This article is part of
Autumn Investment Monitor - September 2015

To put the spike in volatility in recent weeks into context, most of the explanation leads back to China. Back in August, an outsized investor reaction to the fall in China’s currency and dark talk of currency wars quickly gave way to very real concerns about China’s economic strength, compounding the negative mood. But looking ahead there are four main themes that will drive the agenda for asset allocators.

First, the timing of the US Federal Reserve’s rise in interest rates will continue to captivate investors. A rate rise this year is highly likely, on the grounds that the US job and housing markets remain robust, even if inflation continues to lag.

Typically, stockmarkets struggle over the first rate hike – historically they’ve dipped by 5 per cent on average in the three months immediately following, before regaining their poise and outperforming bonds for the remainder of the hiking cycle. Given the focus on the US rate cycle, and the recent de-risking prompted by events in China, markets arguably have already discounted much of the weakness normally seen at the start of a hiking cycle.

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If the domestic US economy is strong enough to justify higher rates, and it is only the recent market volatility that is staying the Fed’s hand, then the start of the hiking cycle should be taken as a signal of normalisation. History tells us investors should dump stocks on the last hike, not the first; cautious optimism on stocks, and a clear ‘buy the dip’ mentality, is still a sensible base case.

Second, while a softening China will not derail global growth, it still has far-reaching implications. China is in the painful process of changing how it achieves growth, aiming for it to stem from consumption and productivity rather than exports and capital expenditure. Liberalisation efforts, such as moves towards floating the currency, are fundamental to this. There is real and concerning weakness in China, but the notion the renminbi’s drop in value constitutes the opening salvo in some global currency war is far-fetched.

Far more profound is China’s reduced demand for commodities, a secular issue that will weigh meaningfully on emerging markets for some time. The ramifications extend beyond traditional commodity producers as the structural decline in commodity prices is likely to affect global inflation.

Third, the European recovery and the aftershocks of the periphery crisis will remain critical. It is noteworthy just how isolated the recent weakness in the Greek economy is from the broader eurozone. A bigger issue will be how the eurozone works through heightened political uncertainty – notably the Spanish election.

European equity earnings growth is outstripping the US for the first time in five years, albeit from a much lower base. Economic sentiment in the euro area remains optimistic, and continued improvements in credit conditions should reinforce the domestic recovery. Significantly for Europe, where around four-fifths of corporate financing comes from banks, lending growth relative to GDP is at its best level since before the financial crisis, adding further support to equity markets over the next 12 months.

Fourth, the dip in oil prices will drive the global markets agenda. Massive inventory growth in the US at the beginning of the year and global oversupply has put pressure on oil prices, and as the US ‘driving season’ comes to an end the inventory overhang is again dictating the oil price. Weak oil, especially in combination with a strong dollar, is not helpful for US equity earnings. If we account for the effect of oil and the dollar, US earnings will be a scratch this year; we’ve foregone a year of earnings growth, but the good news is that we know why, and it’s unlikely to repeat in 2016.