The crystal ball is cloudy
The crystal ball is cloudy
The New Year is typically celebrated with fireworks – the major cities all trying to outdo each other with both colour and impact. It was a seemingly similar start to 2016 for the major markets. Equities slumped across the globe, credit spreads widened, the oil price collapsed and bonds rallied - a tough start to the year by most metrics.
To a significant extent the catalysts were not new. Oil prices continued to fall as both demand concerns (anaemic global growth) and supply concerns (the failure of OPEC to curtail production) aligned, raising fears of deflation and hurting energy producers – including the liquidation of reserves of the major oil producing countries. Likewise in China, moderating trend growth and the structural rebalancing of the Chinese economy away from investment to consumption has been overlayed with a cyclical slowdown driven by the fallout from excessive credit growth and seemingly erratic policy responses as policy makers grapple with the idea and consequences of free floating capital markets. At the same time a moderation in US data (“soft patch”), and concerns about profit growth (especially in the US) have raised concerns about the wisdom of Fed tightening and where it goes from here (will it lower its dots or abandon altogether?). Adding to volatility (and downward pressure on bond yields) was the BOJ’s adoption of negative interest rates on selected deposits which added to the list of central banks reaching deeper into their drawer for additional stimulation to lift inflation and promote growth. Desperate times, desperate measures.
While we were not too surprised by the weakness in China (to a large extent this was inevitable, it was only the timing that was hard to predict), the dynamics of the oil markets and the severity of the collapse in oil prices has surprised us. Likewise where oil goes from here is also problematic and we admit to having little confidence in any particular outcome. While there’s plenty of sound analysis that say the lows have been seen, the conflux of both demand and supply side factors add to uncertainty. We expect / hope the oil price will stabilise and recover somewhat from here – but confidence is low.
These factors make the current economic environment difficult to read and not surprisingly the economic consensus is polarised. As I noted above our own “crystal ball” is distinctly cloudy. What is clearer though, is the distortions that these policy measures impose on investor behaviour and asset prices (both financial and real). One of the underlying objectives of aggressive monetary policy responses (from QE to negative interest rates) is to encourage banks to lend, consumers to spend and provide ample capital for investment. While we don’t know the counterfactual (i.e. what would have happened had these policies not been pursued) we also know that a key missing ingredient has been a substantive recovery in business investment. Instead monetary policy has steered investors and corporates away from pursuing productive capital investments, channelling cash flow into financial assets to effectively play the carry trade in its many forms. Asset prices have risen (be it bonds or equity) so there has been a wealth effect, but this wealth effect has not been sufficient to create a virtuous cycle of demand, leaving economies vulnerable to minor shifts in sentiment and outsized concerns over relatively small market developments.
While there has been some volatility in recent months, the cracks have been emerging for some time. Equity markets have been on the slide since Q3 2015, credit markets have been rebuilding spreads, while sovereign yields have been trading in a wide range with one eye on the Fed and the other nervously watching the worry list (the worry list is currently dominating).
While I’ve admitted above the increasing difficulty in interpreting the broad range of economic data and developments, we have a clearer view of how to invest.
Firstly, we firmly believe that capital preservation is our foremost near term priority. This means we are particularly judicious in how and where we take risk until such time as asset markets re-instate appropriate and commensurate risk premia. We need to continue to focus on how we can manage downside risk in an environment where the traditional risk hedges (like sovereign bonds) are as / more vulnerable (at least directionally) than the growth assets they have typically been useful in hedging.
Secondly, we are reluctant to chase markets in the pursuit of incremental returns. While the momentum trade has rewarded investors it will turn. We prefer adequate valuations anchor our investments rather than the fact that the investment went up yesterday.
How does this look in practice?
Our exposure to defensive assets is high both in absolute terms and relative to equities. Within the defensive allocation cash is preferred, and while it does not offer any more than the cash rate, we at least know this with relative certainty in the short term at least.
Within the equity space our preference remains to be exposed to the cheaper markets – those that have suffered the biggest de-rating and arguably are ahead of the game in terms of pricing the downside. Australian equities are our biggest absolute exposure but still at a relatively modest 15%. Active management of our Australian equity exposure has been a drag on performance as our Australian equity pool which reflects the bulk of this 15% has been overweight resource stocks as value has emerged there and underweight the financially leveraged sectors of the economy. However, we are comfortable this is the right stance and more defensive than the alternative, which would in effect be long momentum – a high risk strategy in our view and anathema to our thoughts on capital preservation. Likewise we have relatively little effective exposure to US equities given our concerns that structural valuations in US equities remain stretched and therefore offering modest return potential over the medium term as a result.
We are starting to see value in credit markets (high yield spreads have widened substantially) and this is something we are selectively adding. We prefer high yield in the context of our medium term objectives over global equities.
Managing downside risk is in part a function of the comments above (i.e. avoiding / limiting exposure to the assets we don’t like) and in part dealing with specific uncertainty. To this end our list of downside mitigants includes duration and yield curve flattening positions, and currency (we still like FX over the AUD). We have taken profits on the S&P put options we had in place broadly since the rebound in markets through Q4 last year, but may look to reinstate should we see a bounce in the market from here.
Finally – and to reiterate the comments we have been making for some time – we expect another tough year.
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