What Has Really Changed In Markets? by Toby Nangle, Columbia Threadneedle Investments

  • With markets in turmoil, it is worth asking what has really changed — and as such whether market falls reflect opportunities or signal threats to patient long-term investors.
  • In our view, there are three medium-sized challenges facing markets for some time that intersect and were brought into sharp focus by the Chinese currency devaluation.
  • We believe that the market correction provides investors with a better entry point for building positions in long-term assets.

The market is still digesting a big increase in energy supply that has occurred over the past 18 months. U.S. shale producers surprised the market time and again with the amount of additional supply they brought to market. Since OPEC countries put on hold their stated desire to defend high oil prices last autumn, production there has also increased, leading to something of a glut which has put downward pressure on oil prices. The Bank of England and New York Fed each estimate that the vast majority of the oil price fall seen has been due to this positive supply shock.* This has been great news for U.S. consumers and has really helped the oil-importing economies of Europe and Japan. But it has also put pressure on emerging market commodity exporting economies and currencies as well as domestic energy producers.

Domestic energy producers are relatively small employers, but make reasonable-sized capital expenditure. The economic hit to the U.S. of the oil shock is pretty modest. However, much of this capex has been made with money borrowed from the U.S. high-yield bond market, to the extent that energy now makes up around 15% of that market. Financial distress associated with oil moving from $100 to $40 a barrel has led us to raise our default rate forecast to c.4.5% for 2016, to energy bonds falling sharply in value, and to bond price weakness spreading across to other parts of the U.S. high yield market. Analogous economic distress has been felt in some emerging markets and has been increasingly reflected in related capital markets. And so despite the good economic news of lower energy costs, risk premia offered to investors in a variety of global equity markets and fixed income markets have been rising. All this makes stocks look marginally less cheap than they used to be versus other assets. Exhibits 1 and 2 show the forward earnings yield (the inverse of the PE ratio) for the MSCI ACWI and the S&P 500 index respectively.

Exhibit 1: 12-month and 24-month earnings yields based on consensus earnings estimates for MSCI All Country World Index versus Bank of America Merrill Lynch US High Yield Index Yield to Worst, 2005–2015

Markets

Source: Columbia Threadneedle EMEA, 08/28/15

Exhibit 2: 12-month and 24-month earnings yields based on consensus earnings estimates for S&P 500 Index versus Bank of America Merrill Lynch US High Yield Index Yield to Worst, 2005–2015

Markets

Source: Columbia Threadneedle EMEA, 08/28/15

Secondly, when we scan the economic data, we see the U.S. economy to be doing just fine. The robust GDP print of +3.7% for Q2 2015 comes in the context of strong forward-looking surveys of confidence. Economic slack continues to reduce, and so it makes sense for the Federal Reserve to hike interest rates. With no term premium to speak of in U.S. Treasuries, this is not the best news for the bond market. And with the rest of the world not doing quite so well as the United States, we have seen a lot of dollar strength over the past year.

Thirdly, China’s economy continues to slow and rebalance away from heavy industry and fixed asset investment. This has put additional pressure on commodity prices – aside from the positive supply shock that was already pressuring them downwards. With the dollar strength outlined above, China has found itself on the wrong end of a large upward currency revaluation in recent quarters, which has posed an additional headwind. Following a collapse in the value of Chinese domestic equities, the Chinese authorities implemented a small devaluation, which to our minds has served as the proximate market catalyst.

The Chinese have for many years taken an incremental approach to policy. The devaluation was only 3%. To put this in context, the euro has moved in a 25% range over the last year against the dollar. So it was not the devaluation per se, but the signal of intent to use currency that has changed. In most emerging market countries, currency weakness has improved their competitive position. However, China’s real effective exchange rate remains at the upper end of its range over the past thirty years at a time when it is facing growth headwinds (Exhibit 3).

China’s currency had hitherto been kept off the table as an instrument of policy, but the combination of: a) a U.S. economy growing above trend and policymakers looking to raise interest rates that has strengthened the dollar to which the renminbi is pegged; b) weaker global growth associated with the commodity-induced emerging markets malaise that has come from a large positive supply shock; and c) the aspiration and associated meandering path towards higher-quality economic growth that poses additional headwinds to domestic economic growth together with a domestic stock market collapse, appears to have changed the calculus.

Exhibit 3: Emerging market real effective exchange rates, 1994–2015

Markets

Source: Columbia Threadneedle EMEA, 08/28/15

Markets perceived this could threaten to export deflationary forces not only on prices but also on profits around the world at a time when the good relative valuation case for stocks was being chipped away by developments in overseas equity markets, domestic and overseas bond markets, and commodity markets.

And so far we have seen equity markets correct with tentative signs of stabilization. We have not panicked but have instead used the opportunity of the correction to build positions further in great individual stocks, pared back assets that rallied into the mayhem that reached full valuations, and extended into favored markets such as Japanese and domestically-oriented European equities where earnings do not appear to be threatened, but valuations have improved meaningfully.

We haven’t changed our view on the Federal Reserve; things look good for the real economy despite some malaise in the energy sector, and we remind ourselves that Janet Yellen and the Fed are cheerleaders for the economy and not the stock market. We are looking carefully for signs of stability in three places that are at the center of the international financial market vortex: commodity markets, corporate bond markets, and the Chinese currency. Having signalled that devaluation is a policy option but with the currency still very highly valued, China will likely see capital outflows rather than inflows on the part of residents and foreigners alike. With these flows, we should also see the associated sales of government bonds by the People’s Bank of China. The prospects for broader market rallies, in our mind, relate meaningfully to prospects in these markets.

Bank of England, 06/26/15; FRBNY, 06/08/15