Given the number of inquiries I’ve received regarding the recent sell-off in global equity markets, I thought I’d share a few quick observations from Signature’s perspective.
Next week, Eric will be holding a webcast along with other team members, so a more detailed perspective will also soon be available.
The quick conclusion is that while we want to respect the changes taking place in terms of market expectations, we perceive the current correction as setting up an opportunity to increase exposure to risk assets and not a time for fear or panic.
Here is a review of our three key risk barometers.
1. Are credit markets functioning?
Yes. Credit markets are the arteries of the system. If they collapse the system is tested. They are still healthy, functioning and resilient. While spreads have recently widened, they remain in a normal range.
2. Is the global economy still improving?
Yes. The global economy is normalizing. It is still growing, however, it may not be growing as fast as some would like. It’s been a low growth, low rate environment.
The S&P 500 Index is now trading close to 14 times expected earnings. This is very reasonable. Given that, our medium-term outlook remains constructive on risk assets, while the following provides further colour on some of the factors driving the recent market correction.
While there is a mired array of plausible causes and no simple answer, I view the root of the current volatility as an overdue market correction triggered by a reset of market expectations for lower economic growth in several geographies. In effect, it is a growth scare that is complicated by two further factors. First, the knock-on implications of slower growth in key constituencies (i.e. commodities and the eurozone). Second, the change in market structure, post-Volker rule, that has significantly impeded market liquidity and left all markets prone to greater volatility during such times of adjustment.
The second aspect is more self-explanatory and helps explain the degree and speed of the stock market correction. However, it is important to highlight that it has had an even more profound impact on rates and FX markets, where the recent intraday volatility is close to unprecedented but is, we believe, the new reality where many liquidity providers (who might have otherwise stepped up to the other side of the trade) have been legislated to the sidelines. Overtime, this should be to the advantage of natural risk holders, such as long-only investors, but at the cost of greater episodic volatility.
It is the first factor noted above, related to the growth scare and its implications that I want to address in more detail. The market has focused on potential slower growth from the U.S., China and eurozone and the follow on implications from that. It should be noted that even as growth expectations are being reduced, the projected growth path for the global economy continues to accelerate, just at a slower pace than previously anticipated. For example, the IMF lowered its 2015 global growth forecast to 3.8% from 4.0%, but that is still still a big uptick versus the 3.3% expected this year. Whether economic fundamentals continue to improve is what matters to us.
Below I will address each of the areas of market concern:
United States: We are not concerned about the U.S. The recovery there remains on track at close to 3%. Nothing so far, including some mixed data, has derailed that forecast or the Fed from ending quantitative easing. I still expect the first rate increase to come in mid-2015 and until the data definitively changes track in either direction from the forecast, this will not change. The Fed is data dependent! While retail sales were a bit soft, industrial production was stronger and weekly jobless claims hit a 14-year low this week. The U.S. recovery remains on track.
China: The concern here is over rated. Of course China is slowing. It is way too big an economy to continue at its historical growth rate and will likely slow toward 5% in the coming few years. The big change recently was increased signs that the Chinese government understands that growth has to slow and a willingness to ease up on stimulus spending even at the expense of missing the 7.5% target. The implication for not hitting the stimulus button, which is very positive for China in the longer term, is that China’s commodity demand will not be juiced enough to absorb the rising supply in many markets. This has helped punch many commodity prices including energy to multi-year lows. To the extent the weak commodity backdrop is persistent, and we believe it likely is, than the knock-on impact into commodity producing countries and currencies is more of a structural rather than a cyclical issue. For those asset classes, countries and currencies the pain will continue. This includes many Latin American countries such as Brazil and currencies such as the Canadian and Australian dollars. On the flip side, lower commodity prices are a boon for commodity consumers. Most particularly, lower gasoline prices are a significant boost to consumers, particularly in the U.S.
Eurozone: In this region, the problems are real. We have argued all year that growth here would roll over and the market is now aligning with our central case. The problem for Europe is that without growth the eurozone countries cannot adjust their relative competitiveness, meet their fiscal targets, pay down their debts, shrink unemployment, and are unlikely to avoid deflation without a collapse in the currency which would entail its own further challenges.
In our view, the path forward to Euro sustainability was outlined plainly by Mario Draghi at the annual central bank symposium in Jackson Hole this past August: They need: 1) aggressive monetary policy, which he has committed to providing to the extent he and the ECB legally can; 2) aggressive fiscal policy to support demand, which Germany is dead set against; and 3) aggressive structural reform, which France and Italy have persistently refused to deliver. Without all three, the Euro will eventually fail. In our view, Europe is not yet ready to give up on the currency. What Europe needs is an agreement between Germany, France and Italy that provides fiscal relief in exchange for measurable structural reforms. This is easy to say, but devilishly difficult to deliver politically. That is why Mr. Draghi is frowning on the outside at the current sell-off but likely smiling on the inside. We need a greater sense of market crisis to prod politicians into moving the Euro agenda forward. More pain will likely be required but we expect some progress will result. We also expect that this process will need to be repeated in some capacity a few more times in the coming years. Watching European policy and markets has become a major focus for Signature, as we believe it is the key risk fault line in the current global recovery story.
To repeat, our view is that this is more of a growth scare and an adjustment of expectations to a lower trajectory of growth – not a derailing of the broader recovery. The growth scare does have other significant implications. It helps reinforce the slower-for-longer global recovery theme which ensures lower-for-longer inflation (with repeated disinflation worries). Ultimately, it is a key plank in the lower-for-longer rate outlook, and that in turn, drives the global yield grab as the key investment theme in the coming years, keeping upward pressure on global risk assets.
At Signature, we reduced our equity exposures three weeks ago as signs of the growth scare began emanating from the commodity markets. We remain on the sidelines today waiting for the opportunity to pick up assets (both equities and corporate bonds) at more attractive valuations. We are not trying to time the market bottom for this, but rather watching for broader signs of stability before deploying our capital. Our central view is that this correction is providing a buying opportunity rather than a reason for panic. Valuations in equity and credit markets are becoming more attractive, while underlying fundamentals remain constructive, particularly in the U.S. The change in market expectations for growth in both Europe and China merely bring the market more in line with our core views.