Investment Strategy: Room for optimism?

Tristan Hanson, Head of Asset Allocation at Ashburton Investments.

Following a period of substantial market volatility,Head of Asset Allocation at Ashburton Investments Tristan Hanson provides an update on concerns over China and how our investment strategy reflects a not-so-pessimistic outlook.

Room for optimism?

August proved to be the worst month for global equity markets for over three years, with worries over China front and centre. The abrupt declines had an adverse impact on our Multi Asset Funds last month, reflecting our moderately overweight stance on equities which had served the Funds well up to that point.

Our preference for equities over fixed income reflects a medium-term view which has not changed with recent events. In fact, we have used the weakness in August to increase exposure to US and European equities using options.

We provide an update in terms of our thinking regarding recent events, the outlook for markets and our investment strategy.

China: the dominant concern

It is impossible to know with certainty why markets move, but fears over China have intensified in recent weeks. With China the world’s second largest economy and the largest trading nation, it is not surprising that events there can have a global impact.

Concern over slowing Chinese growth is nothing new. Similar fears have affected global markets on various occasions in recent years. The same is happening again with weak manufacturing data coinciding with the start of the major equity sell-off.

What is new is that investors are increasingly questioning the ability of Chinese policymakers to tackle their problems (something we raised in July). The bungled efforts to prop up the stock market as well as an unclear strategy for the currency – supposedly move to a market-determined rate but then intervene heavily – has shaken confidence in Chinese policy.

Where is the safety harness?

But other preoccupations have lingered over markets too. The impact of a move higher in US interest rates has been one. For many investors, so too have global equity valuations, particularly in the US.

Perhaps the biggest fear is the lack of policy options if China tips the world into recession. With interest rates at 0%, the Federal Reserve would prefer to tighten policy but even if it reversed course, would further QE do much good? Europe and Japan are already engaged in QE programmes. In terms of fiscal policy, the US could react but there is zero appetite for fiscal stimulus in Europe. Elsewhere, other emerging economies would have very little room to stimulate meaningfully.

Like a professional rock climber without a safety harness, things may be fine. But what if they are not?

Why we are not so pessimistic

We acknowledge that there is always a high degree of uncertainty when it comes to economic projections. We appreciate there are risks to our view.

However, we believe the recent sell-off in developed market equities represents a buying opportunity on a 12-month horizon and we have increased exposure to the US and Europe accordingly.

Our reasons are as follows.

1. We recognise that Chinese growth is slowing - something we expect to continue in the years to come. However, we are not as pessimistic as some when it comes to the question of a financial crisis. First, property sector data has been improving and services appears resilient (as far as we can tell). Second, there is so far no evidence of an abrupt tightening in money market conditions. Third, we expect substantial further easing in both monetary and fiscal policy in an effort to stimulate the economy. Fourth, we believe recessions become financial crises when liquidity evaporates during a credit crunch. The fact that the large Chinese banks are state-owned and the financial sector dominated by government policy, a Lehman-style credit crunch is unlikely to occur in China.

2. The domestic services sector in the US – by far the largest part of the economy – appears to be robust. Recent survey readings of supply managers in the US non-manufacturing sector are at their highest levels in 10 years. Labour market strength supports this view. Moreover, European growth is recovering with three quarters of better growth recorded. There is little suggestion in other indicators and surveys we look at that European growth is about to falter. The ratio of upgrades to downgrades for corporate profit estimates improved last month across the US, Europe and Japan.

3. Global equity valuations are not extremely cheap, but neither do they look excessive following the drop in markets, especially against a backdrop of negative real yields on cash and barely positive real yields on DM government bonds. The 12-month forward Price/Earnings ratio for the MSCI World Index is 14.3x (equating to an earnings yield of 7%), while the forward dividend yield is 3.1% (all figures Source: JP Morgan). So long as earnings estimates do not drop significantly (say by more than 10%) over the next year, we think equities are priced to outperform bonds or cash.

4. We expect the Federal Reserve to raise US interest rates soon, even if it doesn’t happen in September. However, we expect the pace of US rate hikes to be very gradual. Meanwhile, the ECB and Bank of Japan are engaged in QE and we expect both central banks to increase their overall QE purchases beyond current intentions. Monetary conditions in DM therefore remain very supportive. We have increased equity exposure to the US and Europe recently, reflecting these views. We believe the risks remain greater in EM and are currently underweight EM equities, with the exception of India which we continue to believe is an attractive medium-term proposition. Unlike some EM countries, India is a strong beneficiary of falling commodity prices.

What next for China and its exchange rate?

We expect further significant fiscal and monetary stimulus from the Chinese authorities. The ‘impossible trinity’ – the impossibility of a central bank fixing the exchange rate, allowing free capital flows and controlling domestic monetary conditions (See Chinese currency devaluation: Q&A here) – poses a challenge for the People’s Bank of China (PBOC). Capital flows are already negative; increasing domestic liquidity and cutting rates could put further downward pressure on the Chinese renminbi. We therefore expect the PBOC to intervene heavily and it is quite probable that China reverses course on its path towards liberalised capital flows in order to stem pressure on the central bank’s foreign exchange reserves. Our base case is that the Chinese renminbi weakens further to the order of another 5-10% over the next year. The risk scenario is that it weakens much further given the possible pressure on capital flows. In such a scenario, we would expect EM countries and commodities to remain under pressure.

Further reforms are likely to be announced in areas as diverse as household registration for migrant workers to reform of state-owned enterprises (SOEs). There will probably be further debt restructuring as is occurring with local government infrastructure vehicles. However, the path to capital account liberalisation is one reform that has probably ended for now and may even be reversed somewhat.

The above thinking explains our current positive stance on equity markets. Volatility is likely to remain higher than it was in 2013/14, but once the dust settles we expect global equities to move higher over the coming 12 months.

We recognise there are risks to our views. We stay attuned to developments and will change strategy if we believe circumstances merit a different asset allocation.