Central banks, although remaining vigilant on financial stability, are progressively losing effectiveness, and may fail to effectively curb market volatility in the medium term, as they did after the Great Financial Crisis. Financial markets have started to price in a very negative scenario with a re-rating of credit spreads and a deep correction of equity markets, down about 8% year to date(1). However, if our central case scenario materializes – i.e. China does not derail in its transition process towards more balanced growth, Developed Markets remain resilient and avoid deflationary spirals – we believe that the market overreaction can open up value opportunities for long-term investors. We suggest keeping hedging in place to help mitigate the impact of extreme volatility while building exposure on asset classes which have been oversold or which could add income to a diversified(2) portfolio – such as selected Emerging Markets and oversold US credit – as we believe this can pay in the long term.
Today’s Market Volatility is Different Than In the 2008 Financial Crisis
We believe that today we are experiencing different market conditions to those in 2008. The financial sector has gone through a deep deleveraging process in both the US and the Eurozone. Institutions like Central Banks and regulators have played a major role in creating a safety net for the financial sector, recapitalizing banks, and focusing on the reduction of systemic risks. Therefore we attach a very low probability to a 2008-style crisis.
Today market concerns are instead more related to China and to the spillover effects of its transition process. Chinese rebalancing from manufacturing to services, from export and investment to consumption is already having an impact on commodity prices and on economies which are part of China’s supply chain, in particular Emerging Markets (EM). Any sharp deceleration of China would be disruptive for world trade and for global growth, even in Developed Markets (DM), especially in the current scenario of sub-par growth, low inflation, low productivity growth and high debt. A fall in confidence in the success of the Chinese transition also represents a crucial ingredient for crisis. The perception of a mismanagement of the process, uncertainty in managing investors’ expectations, lack of clarity and policy inconsistencies have clearly emerged as material risks in the current environment, capable of triggering capital outflows, disturbing foreign exchange markets and asset prices.
China’s Economic Transition
At this stage, this is not our central case scenario. China’s economic transition towards a more balanced growth model will imply a lower growth rate in the medium term, but a more balanced and sustainable economy longer term. We don’t believe that the Chinese authorities will drive or even accept a massive Renminbi devaluation while they are trying to liberalize the capital markets and while there is a massive amount of corporate debt in US Dollars.
We believe that the currency depreciation will be moderate and we observe increasing evidence that People’s Bank of China is softly targeting the trade-weighted index away from the US dollar. They still have resources to intervene: considerable official reserves to cope with capital outflows and to limit the currency devaluation and a good current account surplus. We acknowledge that these resources are not always properly used and there is a lot of communication noise in a learning-by-doing process. This will bring lot of volatility, but we believe policymakers are determined to successfully overcome this critical juncture of the transition process.
The US Economic Outlook
We continue to see decent growth in the US, especially on the domestic side of the economy. Manufacturing activity is slowing down, influenced by weaker external conditions, but this is counterbalanced by sound service sector and domestic consumption. Low oil prices are giving a positive contribution to household disposable income, and the labor market is still strong. The Federal Reserve will likely maintain an even more dovish stance than expected. So the short term outlook has not dramatically worsened compared to a few months ago. From a longer-term perspective, the situation is more uncertain, as we are not seeing material improvement in productivity growth.
Long-term Investors May Look for Opportunities Amidst Turmoil
Central Banks, while remaining vigilant on financial stability, are progressively losing effectiveness and it is doubtful that the tools at their disposal are going to be as effective in curbing excess volatility as they were over the past five years.
Therefore, we believe that it will be crucial to take a longer investment horizon to deal with this volatile market situation and be focused on value opportunities. If our above scenario is confirmed, we believe that periods of market overreaction, as we have seen in the last few days, should be seen as opportunities for long-term investors. Adopting the appropriate risk management measures, we believe that the accumulation of asset classes that are reaching valuations worthy of attention, or that can add value in terms of income, can be an interesting investment strategy going forward. We see, for example, some opportunities opening up in some areas of the credit space, such as short-term paper in EM – high quality names, in hard currency; or in the US where the credit market is discounting extremely high default rates, especially in the energy sector. In the equity space, we’re seeing wide divergences across sectors and regions and we favor a highly selective approach based on valuations and fundamentals. Emerging Market equity valuations are extremely cheap compared to historic levels. This can represent a very attractive long-term proposition, with a selective approach.
- Source: Bloomberg, data as of January 25, 2016, MSCI World Index considered.
2. Diversification does not guarantee a profit or protect against a loss.