Where next for markets after a turbulent start to 2016?
In the first Schroders Live event of 2016, Bloomberg’s European Markets Editor Mannus Cranny quizzed Keith Wade and Johanna Kyrklund on the most pressing issues facing markets right now. These included matters such as China, the oil price, rate hikes and currency wars.
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Biggest concern for 2016?
Regarding stockmarkets, Kyrklund believes the risks surrounding China and emerging markets are widely understood by investors now. This has been reflected by the underperformance of emerging market equities over recent years and the slump in commodities prices. The bigger concern is elsewhere and surrounds growth, in her view.
“The risk that probably isn’t so well priced-in is if we saw the US growth engine splutter,” she said. “I think the biggest risk to equities is if we started to question the ability of the US to recover against this global backdrop.”
Although Wade agrees the outlook for growth is uncertain, he is also concerned by the intentions of policymakers, particularly in China.
The surprising movements in the Chinese currency this year were “a big signal to the world that China wasn’t happy with the way its economy was performing,” Wade said.
The Chinese policymakers’ decision to use the currency as a policy tool was unprecedented and created a huge amount of uncertainty for markets. This has led to debate about whether we are about to see another wave of currency wars and devaluations, or if China is going to have a hard landing.
“My own view is that we’re not going to go into recession in the US,” he said. “I still think the US is reasonably resilient and what we’re seeing is a soft patch; part of the inventory cycle, not a recession. I don’t think China is going to have a hard landing either, but what concerns markets is what it does to try to avoid that hard landing.”
An additional concern for both Kyrklund and Wade is the knock-on effects of the slump in commodity prices.
“We need to be alert to the potential stress the commodity price fall is causing commodity producers,” Kyrklund said. “So far, the commodity price fall has been a chronic problem, but there could come a point where we start seeing problems like a commodity company defaulting or a commodity-producing nation coming under a lot of pressure. This is one of the risks we have been exploring.”
Equity market opportunities
Kyrklund describes the market of the last few years as “two-tone”. On one hand there have been the beneficiaries of quantitative easing (QE), such as those that benefited from cheaper currencies in Europe and Japan, and growth stocks in the US. On the other hand, more cyclical stocks have lagged.
“We still favour the first area and expect the central banks to remain supportive, but we can’t continue to take risk aggressively on that front,” she said.
“What we need to refresh our portfolios is a stabilisation in global growth, which will help the second axis in equities which has languished; anything that’s cyclical, like emerging markets or resource stocks. There is a lot of value there now and potential pent-up returns. But to unlock that return we really need to see some stabilisation in growth. For now we need to be patient, but there will be opportunities later this year.”
High yield bonds1 are also becoming increasingly attractive in Kyrklund’s view.
“We’re starting to find opportunities to take advantage of yield, not only in equities, but also in high yield debt,” she said. “We have seen a re-pricing (a period of adjustment during which relevant investments will be repriced to account for the extra risk) of spreads and it is an area that’s starting to look interesting again. We believe rates will remain depressed and therefore the search for yield will return.”
The effect of dollar strength
“One of reasons we’re debating whether the Federal Reserve (Fed) can or cannot raise rates is because inflation is so low, and this is connected to the strength of the dollar,” Wade said, pointing out that the strength of the dollar has a negative affect on inflation, by reducing import prices and keeping the price of goods down.
“This allows the Fed breathing space. If it doesn’t want to raise rates in March, it doesn’t have to, for example if the policymakers don’t feel pressurised that they’ll miss their inflation target. The stronger dollar does put some pressure on US companies though and puts a bit of a squeeze on the economy, but as the US is quite a closed economy, we mainly see the effect of the dollar on inflation.”
On the subject of rate rises, Wade is not ruling out another lift in March.
“If the Fed sees signs of the soft patch lifting then I think they will go again in March, but at this stage that looks hopeful rather than reality,” he said.
A weaker dollar would be a boon to markets, Kyrklund thinks. She also doesn’t expect substantial further strengthening and has been diversifying her currency exposure.
“Our central scenario is that the dollar remains strong, but if we start to see concern emerging about US growth and maybe Fed rate hikes are pushed out, you could see a bout of dollar weakness,” she said.
“This would actually be quite helpful for markets, I think. It would take pressure off China and emerging markets, and give the markets a bit of a reprieve. I think the dollar is in a range and I don’t see it strengthening significantly. We have been diversifying into other currencies for risk reduction purposes, such as the yen and - for the first time in a number of years - we have been buying euros, having been short for a long time.”
Where next for the Bank of Japan (BoJ)?
The subject of Japan also centres around China, according to Wade.
“Japan and China are big trading partners and the yen has been one of the strongest currencies against the yuan. The BoJ is looking for wages to start accelerating so that the improvements in inflation can be sustained.”
But Japan faces a similar situation as the US whereby its strengthening currency is dampening inflation. This could cause the BoJ to act, in Wade’s view.
“We think in the springtime they could look at more QE, which could push the yen back down again. This is where we get back into a currency wars scenario – which I think could be quite difficult for risk assets,” he said.
How low can oil go?
Saudi Arabia is currently pulling the strings in the energy market, making for a bleak outlook for oil, according to Wade.
“You can look at the fundamentals as much as you like, but Saudi Arabia has got an objective and that is to drive the US shale gas industry back; and out of business if necessary. They will keep the oil price low for as long as it takes to do that,” Wade said.
“What we’ve learned in the last year or so is that the shale gas industry is much more resilient and can operate at a much lower oil price than anyone expected, so Saudi Arabia has had to be much tougher.”
The battle could go on for some time yet, according to Wade.
“We know from the fact Saudi Arabia is selling reserves, issuing bonds and planning to sell some of its assets that it is building up a war chest for a long fight. To me, the oil price could remain much lower for longer. The equilibrium oil price is probably about $50 a barrel, but it could take a very long time to get back to that.”
1. High yield bond: A speculative bond with a credit rating below investment grade. Generally, the higher the risk of default by the bond issuer, the greater the interest or coupon.↩