Despite a recent market sell-off, we remain neutral on equities in our global tactical positioning. Near-term, the likelihood of more market-friendly central bank statements or action boosting risk asset prices is balanced by the fact there has been little improvement in the key economic indicators we're watching, as well as fresh concerns about credit conditions in Europe.
As we noted in early January, when we reduced equities and added to high grade bond positions, markets are fragile and vulnerable to further shocks. We listed declining oil prices, uncertainties over Chinese policy decisions, and weaker US manufacturing data as factors to monitor. The recent sell-off is being driven by many of the same factors. But additional concerns have also emerged, regarding the European banking system and credit markets.While we would like to see an improvement in the global growth picture before turning more constructive on equities, we estimate markets are already pricing in a roughly 30% chance of a US recession, and continued central bank policy intervention remains an upside risk for markets. Janet Yellen's Congressional testimony tomorrow is unlikely to yield a major Fed policy shift. But there is more scope for the upcoming G20 summit (25-26 February) to provide a platform for global, coordinated policy action.
In such an environment of two-way risks to markets, it is important to remain calm, far-sighted, and disciplined. Investors should consider:
- Utilising market sell-offs as opportunities to rebalance portfolios toward long-term strategic asset allocation targets. Market pricing has become more favorable for investors with a long-term time horizon. In particular elevated levels of stress in European high yield credit are unjustified. The asset class remains one of our global tactical overweight positions.
- Being selective in equity exposure. As bond yields fall amid a flight to safety and in anticipation of even looser central bank policy, companies should benefit whose equities offer growing dividends, or are subject to share buybacks.
- Focusing on long-term investment themes with strong structural growth potential can help investors look beyond shorter-term cyclical concerns. Our preferred longer-term investment themes include water, emerging markets' healthcare, and security and safety.
Investing based on fundamentals and long-term goals is often an uncomfortable short-run experience. Nevertheless, the longer-term advantages of staying close to an investment plan are the rewards for discipline.
In the remainder of this note, I provide some more detail on the key factors we are monitoring, and the market's perception of these risks.
Banking sector risk
The European banks have been among the worst performing sectors in the recent sell-off, falling nearly 30% year to date. The iTraxx Senior Financial index, a measure of the cost of insuring the debt of European banks, has spiked to 132bps, from a low of 66bps in December, indicating heightened default risk in the sector. As we learned in 2008 and 2011, rising credit stress for banks can spill over into more systemic stress, given the banking system's role as the mediator between financial resources and the real economy.
We believe that some concerns are legitimate, namely the impact on banks' earnings of even more negative deposit rates and of lower sovereign bond yields. We view the sharp sell-off in Japanese bank stocks following the Bank of Japan's 29 January policy decision as evidence of how 'conventional unconventional' monetary policy (negative deposit rates and QE) may actually be unhelpful for bank profits and lending rates. We will watch closely for the reaction to further ECB easing, which we expect in March.
However, on a price-to-book ratio of 0.5x, we think that the market may be overstating the risk that European banks will need to raise additional capital. Many banks have already met regulatory capital requirements, and in the absence of a significant deterioration in economic growth, we do not see banks' capital positions as under threat.
US recession risk
The US manufacturing sector contracted for the fourth consecutive month in January, with purchasing managers’ indices close to the lowest levels since 2009. Markets began to believe that this slowdown heralded a US growth recession. While we have been monitoring the manufacturing slowdown for some time, we have been more concerned of late about signs of vulnerability in the services sector. The ISM purchasing managers’ index for non-manufacturing has pointed to slowing growth, and bank lending conditions have begun to tighten.
That said, the S&P500 is now down close to 10% year-to-date, reducing valuations to a 15x 12-month forward earnings multiple. We believe these valuations have already adjusted to reflect the risk of a US recession, to which we attribute a probability of 20-30%. Our base case is for muted, but positive, real GDP growth of 1.5% this year. But labor data continue to indicate a stronger jobs market. The jobless rate has fallen below 5%, the Fed's estimate of 'full employment'. Additionally wages are rising, with average hourly earnings growing at a healthy 2.5% yearly rate. We believe the Fed remains data-dependent and supportive of the recovery, and will follow a modest rate hike path this year unless financial and economic conditions substantially surpass expectations.
China policy risks
Data over the weekend revealed that China's foreign exchange reserves fell by close to USD 100 billion in January, to USD 3.23 trillion. While this was a slightly smaller decline than expected, capital flight from the country is continuing as investors both inside and outside of China attempt to avoid exposure to a feared economic hard landing. As long as this outflow persists, markets will continue to discount the risk of a sharp yuan devaluation and subsequent depreciation from Asian trading partners. We believe the risk of this occurring stands at around 30-40%.
But in our base case, we continue to believe that selective monetary and fiscal easing in China should prove sufficient to stabilize both economic growth and capital outflows, while limiting concerns about a disorderly exodus of international funds from the region. That said, we will continue to monitor China's FX reserves as a gauge of capital flows and tail risks in the region.
Risks from low oil prices
Oil prices have been a critical driver of equity markets in 2016. The 3-week correlation of crude prices to global stocks hit 95% in January. We believe that the market is right to be concerned about oil prices remaining at low levels: we expect the default rate among US high yield energy firms to rise to 15% over the coming year, and energy sector capex cutbacks have already negatively impacted US jobs and economic growth in selected states.
However, we believe the market is failing to appreciate some of the positive factors. We continue to expect the benefit that low oil prices have on consumers' spending power to materialize in the months ahead. Furthermore, cutbacks in output should also help push Brent crude prices back to around USD 55/bbl in 12 months, alleviating the pain for oil producers. For US stock markets, energy's share of S&P 500 market capitalization is around 6.5%, whereas beneficiary sectors such as industrials, consumer staples, and consumer discretionary have a combined weight that is around five times larger.
Risks related to the US economic growth, China, oil markets, and, most recently the European banking sector have driven a sharp sell-off in risk assets year-to-date. We believe these concerns are legitimate, but that markets have broadly priced in these risks. We see potential for intervention from central banks or governments. Given also that our base case is for no US growth recession, we believe investors should take the opportunity presented by the market sell-off to rebalance portfolios back toward long-term strategic asset allocations.
This article was published with permission from UBS.