Schroders Live - Short-term volatility: long-term views
The latest Schroders Live event, hosted by FT Associate Editor Wolfgang Munchau, saw Rory Bateman, Johanna Kyrklund, Gareth Isaac and Matthew Dobbs discuss the recent economic shock in China and the impact of slower growth on the global economy.
Assessing recent market volatility
Please click on this link to watch the replay of the Schroders Live event.
The panel took the view that the move in China’s currency is more significant than the stockmarket drop. Matthew Dobbs described the impact of the stockmarket decline on China’s overall economy as “relatively modest”, although bad news for certain sectors. He sees two interlinked issues facing China, firstly much of the growth since the financial crisis has been down to an unleashing of credit which has created a bubble in areas such as infrastructure and real estate. Working through this bubble is “doable but will take time”, and could result in further short-term volatility. The second issue, which is much more fundamental in his view, is that China’s economy is set to grow more slowly, around 3-4% per annum.
In addition to the slower growth in China, Gareth Isaac cited procrastination by the US Federal Reserve (Fed) as a factor behind the market volatility. “If the US economy, one of the bastions of hope for global growth, can’t withstand a 25 basis point rate hike, then we’re all in trouble” he noted. However, given the problems in China now, he thinks the Fed may choose to delay a rate hike once again.
Johanna Kyrklund sees the move in the Chinese currency as symptomatic of the fact that global growth is fairly weak. This is disappointing, particularly in the face of the stimulus that has been offered by central banks. However, she added that this weaker growth need not necessarily imply higher volatility in financial markets over the coming months if the problems in China lead to a slower rate cycle from the US. “As we go into the fourth quarter, volatility could subside” she added.
Turning to Europe, Rory Bateman noted that the growth slowdown in emerging markets will impact the region’s exporters, but added that the European economy is in recovery mode: “Domestically within Europe we’re confident that things are taking shape; there have been plenty of reforms and quantitative easing has obviously helped the demand picture”. He therefore feels European equities could represent a “safe haven” amidst the slower global growth.
Risk of policy mistakes
Given the likelihood of a lower growth environment, host Wolfgang Munchau asked the panel to consider the possibility of policy mistakes, noting that the Chinese authorities appear to be starting a blame game about the causes of the stockmarket volatility rather than fixing the underlying problem.
Matthew Dobbs concurred with the view that the Chinese authorities may not be entirely in control of events, adding that “the scale of the bubble is something that cannot be pricked in a neat and tidy way” and that there could be some dislocations along the way. However, he also noted that “longer term, a China that is growing at a slower rate, but a China where services are going from 50% of GDP to 70% - which is where they should be – rather than exporting deflation is actually very good news for the global economy. It’s slower growth, but more orderly and disciplined growth”.
Gareth Isaac highlighted that the Fed has been a part of the problem in not raising interest rates, giving the impression that the US economy was too weak to withstand a hike. In his view, a rate increase, coupled with an upbeat statement about the outlook for the US economy, could serve to restore some market confidence.
The panel agreed that although dislocations in the market are to be expected in the short-term, this is not necessarily all bad news. Commenting on the fall in commodity prices, Gareth Isaac described this as “unequivocally good news for developed markets such as Europe, the US and UK but also emerging markets such as China and India”.
Focusing on risks in Europe, Rory Bateman commented that he is “not too concerned about Greece” given that there has been significant progress made on resolving the issue in the short and medium term. Instead, he said a greater worry is how the Chinese authorities manage a potential hard-landing: “What we need to see is more balanced, more rational policies to ensure that the transition from an industry- and infrastructure-led economy more towards consumption happens over a period of time”.
What are the implications of low growth for investors?
Host Wolfgang Munchau turned to the implications of lower growth for investors, in particular asking the panel about the likelihood of big asset shifts into or out of advanced economies. Johanna Kyrklund observed that “value overwhelmingly resides in the most cyclical areas of the market: commodities, emerging markets, and resource sectors. The problem is that with this weak global growth environment, we lack the catalyst to take advantage of that value”. She said money has already flowed into developed markets and that defensive areas of the market are already starting to look quite expensive, and may become even more so. As a result “prospective returns look fairly muted over the next 6-12 months” in her opinion. However, should an opportunity arise to rotate back into these value assets, then that is when there could be a real boost to returns.
From a European perspective, Rory Bateman cited intra-European trade as the main driver of the region’s recovery and, as a result, companies focused on that domestic trade appear the most attractive, in his view. Exporters are more at risk from the China slowdown, although China represents only 10% of European exports. Looking at the implications for Asia, Matthew Dobbs noted that valuations have pulled back a long way and observed that “Asia doesn’t stay cheap for long”. He also noted that the underlying growth offered by some Asian markets is likely to prove attractive in a global environment of low growth.
Gareth Isaac highlighted that the current scenario offers an opportunity for active managers as there is now greater differentiation between markets. He also emphasised that emerging markets are not a homogenous group: “Some emerging markets will do better out of a weak commodity complex than others”.
What is the outlook for commodities and currencies?
Johanna Kyrklund attributed the fall in commodity prices to “a dearth of demand in the global economy; we generally expect commodity prices to remain quite low”. On the other hand, she also noted that commodities are extremely out of favour now and may at some point start to offer value relative to other asset classes. A stable or weaker dollar would be favourable for commodity prices, in her view, adding that such a scenario could occur if the Fed were to signal a much flatter trajectory of rate increases.
Picking up the currency theme, Wolfgang Munchau raised the likelihood of the European Central Bank (ECB) missing its inflation target next year, which could prove a catalyst to extend quantitative easing (QE) and in turn provides a structural pressure for a weak euro. In response, Rory Bateman noted that “the deflationary impact from commodities is very significant and that is what is suppressing Europe’s inflation numbers”. In terms of the impact on equities, he noted that QE provides liquidity and is good for the European equity market. He also added that in his view ECB Chairman Mario Draghi is aware of the importance of the euro and still has plenty of firepower to make adjustments through rhetoric or policy changes.
Prospects for fixed income
Gareth Isaac noted that amid ultra-low interest rates, cash hasn’t been an investment option and as a result many investors have been forced into riskier assets. If interest rates start to rise in the US, there may therefore be some dislocations in the market as investors switch back out of these. However, if the Fed keeps rates at zero, then he thinks the hunt for yield will continue: “Baby-boomers in the US and Europe are retiring and they need an income. They’re not getting it from cash so they need to find it somewhere else”.
Falling global reserves were another issue highlighted by Gareth Isaac. After 10-15 years of reserves rising, he observed that countries in the Middle East are trying to survive with oil at $40/barrel and therefore are having to subsidise their budgets by selling US Treasuries. As a result of this, he says “even though interest rates may remain low, bond yields could have a difficult time as we start to see global reserves fall”.
Growth to command a premium
In conclusion, Matthew Dobbs commented that we are “nowhere near the much-prophesised death of the equity” and reiterated that growth is “likely to remain highly prized”. In particular, he highlighted small caps as a potential area of interest as they are in the right niches to offer growth. He noted that although overall growth in Europe has been low, there has been a strong market for small caps and they still do not look expensive.
Please click on this link to watch the replay of the Schroders Live event.