2016 starts with a thud as markets tumble
Shares have got off to a very bad start for the year triggered by many of the same worries seen last year
A sharp fall in Chinese shares and the value of the Renminbi, which in turn triggered renewed worries about the Chinese economy; the weaker Renminbi triggering more commodity price weakness and fears of an emerging market crisis; some soft US manufacturing data; and geopolitical risks, this time regarding Saudi Arabia/Iran tensions and North Korea. Consequently all share markets have seen sharp declines (with US shares falling -6%, Eurozone shares -7.2%, Japanese shares -7.0%, Chinese shares -9.7% and Australian shares -5.8%), commodity prices are down further with the oil price falling to its lowest since 2009 and bonds have rallied with safe haven buying.
The poor start to the year clearly warns that global growth concerns remain, that commodity prices are still under downwards pressure and that volatility in investment markets will likely remain high. However, it is worth putting these developments in some perspective:
The latest fall in Chinese shares may have a bit further to go but looks to have been exaggerated and driven more by fears and regulatory issues around the share market and currency rather than a renewed deterioration in economic indicators.
While the Caixin business conditions PMIs were weaker in the last week Chinese economic data had shown encouraging signs of stabilisation during December. Chinese property prices rose, indicating that the gradual property market recovery is continuing. Industrial production rebounded to a 6.2% annual pace, while retail spending accelerated to an 11.2% pace. China’s inflation remains mild at 1.5% meaning there is considerable flexibility for China’s central bank to cut interest rates further to support growth. There are still signs of weakness with China’s manufacturing conditions indices providing mixed signals but essentially remaining soft. Services conditions indices remain reasonable. All in all, Chinese growth appears to be stabilising around a 6.5-7% pace as opposed to collapsing.
Rather the main drivers of the renewed volatility were worries about new share supply following the scheduled end to a ban on selling by major shareholders, a new share market circuit breaker that commenced on Monday 4 January which appears to have added to market volatility rather than calmed it down. The 7% threshold for a market fall to trigger a shutdown was too tight, and inadvertently encouraged investors to bring forward selling in an effort to beat the shutdown and a continuing depreciation of the Renminbi.
Chinese regulators have since announced a restrictive limit on the size of stakes that major investors can sell; the circuit breaker has now been suspended after the experience of the last week; and after 6% plus depreciation in the value of the Renminbi since July the People’s Bank of China is now likely to step up efforts to try and stabilise it again much as it did through September and October. The depreciation of the Renminbi is the key issue at present as its decline is helping fuel upwards pressure on the US$, adding to weakness in oil and other commodities and keeping alive fears of some sort of emerging market crisis. Fortunately, Friday did see some stability return to the Chinese share market and currency but it needs to be sustained.
While the US ISM manufacturing index has been softer lately and is a concern, most US data points to stable underlying growth of around 2% or so. US economic data was mostly positive during December and as a result the US Federal Reserve’s (Fed) interest rate hike was not a surprise. There were healthy gains in both jobs and retail sales and wages growth is continuing to trend up. While durable goods orders were on the soft side and existing home sales fell, consumer spending was solid, consumer confidence edged higher, new home sales rose and September quarter gross domestic product growth was stable at 2% annualised. Meanwhile, inflation remains at 1.3% year-on-year, well below the Fed’s 2% target. A sharp fall in the ISM manufacturing conditions index was disappointing and highlights the pressure the US manufacturing sector is facing from the rise in the US dollar, however, the broader Markit manufacturing conditions index is holding up much better and services sector conditions indexes remain strong, although they have slowed a bit. There were weak readings for manufacturing conditions in the New York and Philadelphia regions and a slight fall in the National Association of Home Builders’ conditions index but very strong gains in housing starts and permits, strong leading indicators and a larger than expected fall in jobless claims.
Signs that global growth remains fragile and constrained will have the effect of ensuring that global monetary policy remains easy this year, with US Federal Reserve tightening likely to be very gradual with maybe just two 0.25% rate hikes this year, Japan and Europe continuing with quantitative easing and China continuing to cut interest rates. The continuing global weakness also adds to the case for the Reserve Bank of Australia to cut interest rates again.
Structural issues in emerging markets require structural and potentially more painful solutions. Emerging market foreign exchange reserves and flows will likely cause further rebalancing and volatility. We would like to see oil and commodity prices stabilise, China policy gain greater traction and sentiment improve. While the broader European region is in good shape politically and has a strong policy toolset to protect against contagion, the ongoing bailout discussions for Greece and execution risks as well as anti-austerity party movements across the periphery may drag on sentiment. Global central bank policy and liquidity conditions continue to drive differing investor behaviour. Yet a rise in volatility across asset classes has ensured there is also an acknowledgement of market impact during this difference in timing and transition phase for global central banks.
The tensions between Sunni Saudi Arabia and Shia Iran have been building for a while and partly flow from the US’ shift in military focus away from the Middle East. However, while they will continue to show up in wars in the region, e.g. in Syria and Iraq, they are unlikely to result in outright direct conflict in a way that dramatically pushes up oil prices. In fact in the short term the tension ensures that OPEC will remain paralysed with Saudi Arabia focused on maintaining high production to inflict pain on Iran and Iraq, which will serve to keep oil prices low (or lower) for now.
North Korea’s H bomb test is a big concern but there is some question as to whether it was really an H bomb and it has already had three nuclear tests since 2006. So overall, while it’s been a very poor start to the year for equity markets and risks remain high in the short term our expectation remains for better returns this year than we saw in 2015 as share market valuations are reasonable being cheap relative to bonds and bank deposits, global monetary conditions are likely to remain very easy and this should in turn help ensure a rising trend in share markets, albeit with bouts of volatility along the way. While it’s hard to maintain confidence in Chinese shares, it’s worth noting that those listed in Hong Kong provide particularly attractive long term value trading on forward PEs close to 6 times, less than half that of Australian shares.
Worries about the China and the US Federal Reserve are likely to drive continued volatility in the short term until some stability returns to the Renminbi and US$ and hence in commodity prices.
Chinese economic outlook
The rapid pace of deterioration in Chinese data has ended, and while the data remains mixed, aggressive falls in data series have not continued. Consumption and services remain reasonable, however manufacturing and housing still face considerable challenges. Regional growth in exports has picked up on the technology product cycle but has yet to show convincing signs of broadening out to other sectors, and technology inventories remain high, limiting the extent to which the export sector is generating activity in manufacturing. The risk therefore remains that this improvement is both short and shallow. We continue to expect China to face structural headwinds as its economy reorients its growth drivers. It is likely the People’s Bank of China will continue to support the economy via required reserve ratio cuts going forward.
US economic outlook
In the US, the medium-term cyclical dynamic still appears reasonably positive, driven by ongoing improvements in the labour market. While housing data has become more mixed recently it nevertheless shows significant improvement from the first half of 2015. Given that backdrop, consumption is lower than one would normally expect with the tailwinds of a housing wealth effect and a lower cost of oil. Overall consumer sentiment remains reasonably strong however, which is not surprising given labour market dynamics and increasing wage growth. Recent manufacturing data points to some slowing, in part because of the strength of the US dollar impacting on exports, the lack of investment in the oil industry impacting on capital goods orders, and the inventory backlog that will act as a drag on manufacturing over coming quarters.
The December jobs report was particularly positive with payroll employment up much more than expected at 292,000 and employment in the prior two months being revised up but increasing participation keeping the unemployment rate unchanged at 5% and wages growth coming in weaker than expected at 2.5% year on year. The strength in jobs tells us that the US economy remains solid, but rising labour market participation and soft wages growth gives the Fed plenty of breathing space on interest rates. Meanwhile the minutes from the Fed’s last meeting reinforced the focus on “actual and expected inflation” moving closer to target when considering future rate hikes, so it’s hard to see the Fed being anything but gradual in raising rates as weak commodity prices will continue to constrain inflation. The next Fed hike is unlikely till March but this could be delayed if global growth concerns, market volatility and falling commodity prices continue.
The US remains the bright spot for developed markets and weakness in other parts of the world will likely continue to act as something of a drag on US growth.
Equity markets outlook
Beyond the short term we still expect shares to trend higher, helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. But expect volatility to remain high.
International shares – Global shares are likely to be helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. We favour Europe (which is still unambiguously cheap and seeing continued monetary easing), Japan (which will see continued monetary easing) and China (which will also see more monetary easing) over the US (which may be constrained by the US Federal Reserve and relatively high profit margins) and emerging markets generally (which remain cheap but suffer from structural problems).
In terms of global REITs, we are most positive on Europe and Japan. We continue to monitor China and the concerns over growth. We will also closely monitor commentary by the US Federal Reserve regarding interest rates, as well as the underlying economic data which is likely to drive its decisions. The large discrepancy between prices in the private and listed markets continues to benefit REITs and we expect large transactions to occur in the direct market globally, particularly the US and Europe (including the UK), as we continue to see strong demand from investors around the world.
In terms of listed infrastructure, the market remains volatile as we head into the new year, particularly for energy sensitive stocks. There is currently much focus on the changes in the global oil market and the ‘lower for longer’ crude oil environment. However, our view is we are in a ‘lower for longer’ global yield environment and we believe the US Federal Reserve will be cautious and not raise rates too quickly while the rest of the world remains weak. Overall, we believe global listed infrastructure will remain supported by a secular growth tailwind, stable and sustainable cash flows and above-average dividend yields.
Australian shares – Australian shares are likely to improve as the drag from slumping resources profits abates, interest rates remain low and growth rebalances away from resources. But they will probably continue to lag global shares as the commodity price headwind remains.
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