2016 has seen a horrible start for global and local equity markets. Concerns about global growth, and therefore equity earnings, have intensified. This has resulted in a global P/E contraction in equities to reflect rising risks (higher equity risk premium), and a big rally in long government bond yields.
Outside of government bonds, gold and the USD there really has been nowhere to hide. In equities it has been the equivalent of a clearance sale at a department store, with just about everything marked down in price.
The speed of this sentiment change is somewhat stunning. Equity markets had ended 2015 with a decent rally and it appeared things had calmed down a little after a massive year of volatility. How wrong that assumption proved with global and domestic equity markets roaring back into bear mode with a vengeance.
The biggest problem we all face is that concerns about emerging markets that were apparent /obvious all last year have spread to developed markets, with the world now strongly questioning whether the US Federal Reserve made a policy mistake with its December rate rise just as US economic data started slowing.
This is a classic “growth scare”, but it’s a very serious and damaging one. Whether this is just another “scare” or the start of a “bear” only time will tell, but unfortunately I have to tell you there are several indicators that point to this being more than just another “growth scare”.
We have seen emerging market currencies collapse, commodity prices collapse (led by oil), junk bond markets collapse, Chinese equities collapse, inflation expectations collapse, global growth forecasts revised down, equity earnings forecasts revised down and many technical analysts saying that multi-year technical support for equity markets has given way. Similarly, instead of “dips being bought”, as was the case for the previous 5 years, any rallies are now being sold.
Probably the most interesting aspect is stocks that have led the bull market, such as Apple, have now run out of earnings growth (blaming weak global growth and the strong USD). Even market darling Amazon fell 15% after not meeting market earnings expectations.
You can understand why I think this is different to other “risk off” market moments over the last 5 years. There are simply too many top down macro and bottom up earnings indicators pointing to the world slowing down and having a genuine “growth problem”. If we have a growth problem we broadly have an equity earnings and dividend problem. It’s very hard for equity markets to broadly advance if earnings are going the other way.
What has also changed this year is the view that the US economy would be unaffected by weakness in the rest of world (ROW). All economic data from the USA from late last year and early this year has been unquestionably weak. It would appear the strong USD and weak trading partners have genuinely slowed US economic growth.
While the shining light has been employment growth in the USA, employment growth is the most lagging indicator of all. Forward looking indicators like purchasing manager indexes (PMI) have headed into recessionary readings which is genuinely concerning.
Don’t get me wrong, I’m not predicting a US recession, but a slow growth patch has started and it’s clearly having an effect on Wall St. The simple fact is the US economy is NOT IMMUNE to global issues nor is Wall St. US 10yr bond yields @1.85% are trying to tell you this very point.
The issue has become that central banks simply can’t drive global growth. Central banks can drive asset values and home currencies, which has been the case for the last 5 years, but sustained global economic growth requires concerted fiscal (government spending) and corporate support (capex and hiring).
There is only so much central banks can do to drive global growth. Ultra cheap sustained monetary policy forces savers up the risk curve and in turn drives risk asset prices, but risk asset prices also need earnings and dividend growth to sustain those prices. The missing piece globally remains fiscal policy support and corporate spending. Easy money monetary policy simply can’t sustain lasting global growth unless they are supported by reforms to boost investment and private sector confidence. The problem is those moves tend to be tough, drawn-out, and socially disruptive, and governments often struggle to execute them. In the medium term the world remains in a clear “currency war”. It’s every country for themselves in attempting to devalue their currency to drive growth. Again this is a zero sum game and simply drives cross asset class volatility. You can all see the volatility even a small devaluation of the Chinese RMB has caused.
The problem is central bank activity is becoming less and less effective. Think of it like a patient who has been on morphine for an extended period. The dose needs to get higher and higher to have an effect. You can also see what happens when the doctor tries to lower the dose (Fed).
A classic example of a central bank “pushing on a string” is the Bank of Japan. On the last day of January they surprised markets by taking cash rates negative. The Yen fell -3% and the Nikkei rallied +5% over two days, only to give all those moves back in February. It was a very short party because guess what the Bank of Japan can’t do with monetary policy?? Fix Japans rapidly aging population.
My point is for the best part of 5 years an investment policy based off “front running” central banks worked very well. My strong advice to you all is those days are over.
My key message is that simply hoping for a rising equity index tide to lift all boats is not going to work. In fact, that approach will most likely continue to detract value as has been the case for the last six months.
What I believe is the right approach is high conviction stock-picking where you can see structural earnings and dividend growth. In a world lacking growth, paying a bit of premium for earnings and dividend growth where you can find it would appear to me a sensible approach.
The pending Australian 1H FY16 reporting season will confirm where earnings growth is and is not. I expect some pretty extreme share price action in that reporting season where those who confirm growth continue to outperform, and those that don’t continue to underperform.
That may well sound like a ridiculously obvious statement, but in these markets we need to strongly resist the temptation to be premature contrarians. The trend has been your friend and will most likely continue to be.
In the weeks and months ahead I will write to you about stocks we think offer those structural growth attributes. Late last year I mentioned Baby Bunting (BBN) and Link (LNK) as having those attributes and both have done well in this deep broader market correction. There will be others and my investment team and I are looking for them right now.
I expect further volatility and high levels of stock price performance divergence. What we always need to remember, and its damn hard some days, is it is a market of stocks, not a stock market.
In the fact just about everything has been marked down in price there will be stock specific opportunities to invest and make money. There should be absolutely no doubt about that.
But make no mistake, this is different to the last 5 years. We will need to be highly selective in where we allocate capital. We will also need to be patient and disciplined.
I realise everyone wants to be told it’s a buying opportunity. No doubt it is in the RIGHT THINGS, but if I look across what different indicators are telling me most are flashing “orange” and some “red”, it is absolutely NOT the time to be BUYING EVERYTHING.
I’m sorry to start the year with a dose of bearish reality, but I think we first all need to get our mindsets into the right framework and acknowledge that we are in a serious global growth scare that has spread to the USA and that most likely won’t end tomorrow. Keep your seatbelts fastened this is going to remain a bumpy ride. A bumpy ride with plenty of opportunities for the patient and forward looking.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.