Over the previous six months global equity markets have dropped rapidly from a great height, and, according to Harbour Asset Management portfolio manager and director, Shane Solly, investors could face a long climb back to the top…
Markets are in a corrective phase led by sentiment. There is a saying in investment markets, ‘markets go down by the elevator and come up by the stairs’. We have just gone down the elevator.
However, history tells that after 15% market corrections, such as we have seen over the last six months that the subsequent 6-12 month performance is varied and flattish on average. Australian market corrections of 15% over 6 month periods have occurred 13 times since 1960, as shown in figure 1 below.
Figure 1: 15% Australian market corrections over 6 month periods have occurred 13 times since 1960
Source: Harbour, Deutsche Bank
Research by Deutsche Bank shows that if corrections that were followed by economic recessions were excluded, the Australian market has risen by an average of 10% subsequently (illustrated in figure 2). On only one occasion was the market lower a year after a correction. While we do not expect strong economic growth, we are not expecting a recession.
Figure 2: The Australian market has rallied 10-15% 6 months post a 15% correction where no recession
Source: Harbour, Deutsche Bank
Markets to grind higher
While market pricing globally may have improved, conditions for a sustainable bottom may not be in place yet. There is some short term risk the market trades further below its underlying value as emerging market weakness continues to impact on developed markets including New Zealand and Australia. In an increasingly globalised economy, excesses and imbalances in one corner of the world inevitably affect other countries, with the U.S. subprime mortgage bubble the last big example. China is home to some of the biggest excesses, with vast over investment in everything from chemicals to apartments. Given the increased inter-connectedness of economies and markets, unwinding of imbalances can lead to increased capital markets volatility.
Volatility may dissipate as global liquidity improves.
There are some short term factors that may have exaggerated recent market swings. Seasonal illiquidity with northern hemisphere investors on holiday during recent ructions may improve as these investors return to their offices. The unfortunate events in Tianjin and slowing in Chinese manufacturing to reduce pollution prior to the 70th Anniversary of the victory over Japan commemorations may have accelerated the rate of slowing in the Chinese economy temporarily. Unwinding of leverage in the developing but currently over geared Chinese stock market may take a little more time.
Increasing scale in trend following quantitative funds, some smart beta passive funds and momentum investors known as CTAs, mean tail events in volatility can exacerbate deleveraging flows. In particular such fund’s buy equity market exposure as overall market volatility falls and sell equity market exposure as overall market volatility increases, increasing the speed of a markets directional move. These strategies have become increasingly popular as they provide yield enhancement for investors where cash and bond yields are low. Such funds adjust their exposures according to algorithms in response to market moves. Spikes in volatility can trigger a series of automated sell orders from such Funds.
Contrarian sentiment indicators are showing extreme bearishness. Long only equity funds are long cash, hedge funds are at high short levels (they have sold the market or specific stocks), equity market breadth is narrow (being influenced by a small number of stocks), bond fund investor cash inflows are high and equity fund investor cash outflows have increased.
At Harbour we focus on the fundamentals. Economic growth, earnings and dividends, and interest rates are more important for equity market returns than daily noise. While earnings growth forecasts have been trimmed company profitability remains relatively high.
The macroeconomic background will provide a mixed lead for equity returns in the near term. While Macro economic growth will be hard to come by this doesn’t mean equities will do badly. There is plenty of monetary policy ‘runway’ locally and fiscal space to provide some offset for the New Zealand and Australian economies. We see potential for both the RBNZ and RBA to cut official rates further – interest rates will need to stay lower for longer to offset lower growth, providing some support for equities.
The Chinese Government has the difficult task of needing to lower domestic interest rates and devalue to support its transitioning economy without blowing up Asia. But September is more likely to be about the US Fed – while the Fed will begin normalising US interest rates over the next year it is in no rush with US inflation levels staying relatively low.
Structural themes such as Healthcare spend, technology development, emerging economy consumption changes, trade/globalisation (including urbanisation), and energy use may support returns for stocks that benefit from these themes.
But we can see the conditions are already building for markets to start ‘climbing the stairs’ over the next year.
Local market pricing is no longer as full as it was. While the current profit reporting season has been mixed, company balance sheets are generally in good order to weather an extended period of weak activity. Cash and bond market investors seeking yield enhancement remain the marginal investors in equities. The dividend income yield on a portfolio of local stocks (prospective dividend yield of 5.1% for the New Zealand market and 5.3% for the Australian market) looks attractive relative to fixed interest investments. There is also the potential for increased corporate activity once markets settle down. Brookfield Infrastructure Group’s takeover of A$1.9bn Australian listed company Asciano in August highlights that investor interest for companies with moderately high earnings certainty remains elevated.
Overall equity market volatility is likely to continue to increase to more normal levels from abnormally low levels. We expect stock selection to play a significant role in determining portfolio outcomes. Our investment process which focuses on sustainable growth and quality has provided an ‘anchor’ to portfolio performance over previous periods of increased market volatility, and we expect it to continue to ‘weather’ potential market ‘storms’.