The recent sell off in commodities and resources caused by a slowdown in Chinese manufacturing, has caused anxiety to spill over into main markets. This perhaps shows a lack of confidence in valuations that were boosted by stimulus, and where the US appears still on track to raise interest rates by the end of the year.
Japan has gone back into deflation, Euro area inflation is at 0.1% and US inflation sits at 0.3%. On the face of it inflation is not a problem, and there is no need to increase interest rates. I think the Fed just wants to be seen to be trying to get back to normality, but correctly did not do anything earlier this month, as it could have made things worse for emerging markets.
If the current level of volatility continues, it is not beyond the realms of possibility that we will see additional support measures being introduced.
The fundamental ‘take-away’ from the current situation is that the Fed has no rule book to follow. The world has never had to deal with weaning markets off six years of stimulus before. It will be a slow and gradual transition, with more volatility than we have been used to, with ‘risk management’ taking centre stage, rather than shooting for the big returns.
A lot has been written about the recent dip, and so I’ve gone behind some of the headlines, to help shine more light on what’s going on.
‘Wait and See’!
The Federal Reserve met on the 17th September for their eagerly anticipated first interest rate rise in nine years, only for markets to be disappointed with a ‘No Change’, ‘Wait and See’ approach.
During the press conference that followed, the Fed confirmed it had concerns over the slowdown in China, its effect on emerging markets, and to complete the circle, the effect this was having on its own inflation targets. There was a hint of worry about deflationary pressures, because US inflation is only at 0.3%, way below the Fed target of 2%. The Fed confirmed that recent
developments don’t fundamentally change the positive outlook for the US economy, it’s more a timing issue.
However, the following day markets were a little spooked by the shift in Fed thinking, from ‘buoyant recovery’ in July, to ‘global concerns’ in September, and so in the last week the Fed has again signalled that the first rate rise is on course for later this year.
That said the Fed is still waiting to see more data on the impact of the recent Chinese devaluation and emerging market problems. Next week we start to get Q3 earnings reports in the US, and so a great deal rides on how these show that the US economy is indeed strong enough to raise rates.
Why is China having an effect?
China’s manufacturing economy has been slowing down, but in the summer the slow down seemed to speed up, and this has had a knock on effect to commodity companies and emerging markets, who produce most of the raw material that China was consuming.
Whilst on the face of it the USA and UK don’t appear to do a great deal of trade with China, we are exposed through the global banking system, who have lent heavily to both China and emerging markets.
Therefore last Friday, the 25th, the Financial Policy Committee of the Bank of England warned about China and emerging markets, and the possible effects on the financial stability of the UK. They said that if there is further trouble in commodity markets, this could increase the emerging market slowdown, and effect the UK.
Is this transitory, or has something fundamentally changed?
I was interested to hear the views of two of the FT’s heavyweights, John Authers the Financial Times’s senior investment commentator, and Martin Wolf chief investment commentator and associate editor. They discussed that the Fed had effectively admitted they don’t know what’s going on in China, and that the Fed took the position it was possible that a ‘tail risk effect’ could affect the US economy. Hence ‘Wait and See’.
Broadly they summarised two scenarios,
1) Recent events are all noise, Emerging Markets are dented but ok, and as data comes through on the continued strength of the US recovery, markets will be happy and the Fed will raise rates by the end of the year.
2) Things start to look pretty bad over the next three months, with a continued slowdown in China, and that possibly rates get cut to promote stimulus and avoid deflation.
No conclusions or predictions were offered, however my observation is that whichever route becomes reality, the next few months will continue to be volatile.
This is because the perception and sentiment, is that China will continue to slow, and that this will continue to impact upon emerging markets. A slowing China, much like a slowing oil tanker, is not something you can turn around overnight.
That said, to date figures from the US show that recent events have not impacted upon the US recovery, and so for now things look transitory.
So at this time, it’s more a case of ‘fastening your seat-belts’ for a bit of mid-flight turbulence, rather than an outright crisis.
The Downside Risk
The flipside to a ‘transitory’ situation is a worsening emerging markets crisis. The latest Chinese flash PMI figures (Purchase Managers Index) a barometer of the economy, released on 23rd, show that manufacturing is at its worst level since 2009. To stimulate their economy the danger for the West is that China devalues its currency further, which effects emerging markets, which depresses our stock market.
It’s not clear how justified this would be, but we can see that raw material prices have collapsed as China has slowed. Even though a sell off might not be justified, markets can be irrational for a time and overshoot on pessimism.
The test will be USA Q3 earnings figures in the coming weeks, and that the US economy is strong enough to raise interest rates before the end of the year, as the Fed indicate they still wish to do.
My view this year has been that bonds offer little value in a rising interest rate environment, and as I wrote earlier this year, they had begun to stagnate and become more volatile.
Last October there was a ‘flash crash’ in US treasuries, and even though it only lasted for a matter of minutes, it showed up the underlying problems of liquidity, and that an enormous market for a perceived safe asset, could lose stability in an instant. (Source FT)
Therefore, even with the deferral of a rate rise in the US, rates will rise at some point, and so we want to avoid potential volatility and liquidity risk from this asset class.
So where clients have been holding pure fixed income and bond funds, we have had to rethink and rotate out of these, to other low risk or ‘risk managed’ alternatives.
A nimble and adaptive approach is required to park profits when made, as ‘going long’ and holding onto assets that have made gains, can mean that those gains are simply taken away again, when markets behave as they currently are. A profit’s not a profit until it’s taken.
Where we are taking over portfolios that hold things that we would not ordinarily include, we may have to hold onto some of these assets, for a little longer, as some holdings maybe nursing short term losses. That said it’s still possible to offset this by bolstering defences elsewhere.
This means a deeper dive on reviewing existing equity holdings to see what is working and what is not. Even in the current dip, through stress testing we can see which funds have coped better than others. It tells you more information about the ‘risk personality’ of the fund.
Equities continue to be volatile, based on sentiment over recent events in China, but value can found in certain sectors and where certain managers through stock selection, have provided better stability in the recent dip, than say a FTSE 100 tracker.
During times of uncertainty there are also opportunities to pick up assets at lower prices for the long term, and so a drip feed from cash or lower risk assets into equities can be effective. By using assets that have been minimally affected by recent events, and have held their value, it’s possible to position for the future.
This does not mean an immediate uplift in values, and of course values could dip lower before they recover, but it does position you for the future, in order to gain from a broader resumption of confidence as the US recovery strengthens.
We are well known for our risk managed approach, Cautious Blend® and Safe Harbour Planning®, something I feel will become increasingly important.
- We have a ‘divergent’ global economy, with over twenty central banks cutting interest rates this year to stimulate their economy and avoid deflation, and then you have the USA and UK thinking of raising interest rates!
- China has not derailed the US recovery so far, it’s more delayed the timing of US interest rate rises.
- The ‘Wait and See’ approach in the USA has meant the continuation of a bumpy ride. Markets don’t like uncertainty which is why the Fed have come out last week to confirm that an interest rate rise is still on the cards by the year end.
- There has been a big shift in the Fed stance, focusing on the ‘global economy’, but the Fed is still concerned with what’s best for the US recovery.
- The Fed is ok with the path of unemployment falling, it’s more concerned in not upsetting the recovery, by raising interest rates too early.
- The Fed expects downward pressure on inflation in the short term, but expects this to be transitory, as its economy continues to strengthen.
Commodities and emerging markets will continue to be messy, affecting our stock market.
Markets are looking for China to stabilise and further news of US economic strength.
Equities will be bumpy in the interim, until we see a strengthening US economy, or some further support measures if things were to deteriorate in emerging markets.
Austyn Smith is a leading advocate of the ‘risk managed’ approach and ‘all weather’ investing, and has been featured as a Citywire ‘Cover Star’ in both 2010 and 2013.
Following his work on risk reduction strategies, in 2011 he was recognized by Citywire Wealth Manager magazine as ‘Being in a position of some influence among your peer group, and likely to take a leading role in setting the investment agenda for UK Private Client managers.’
Austyn has recently contributed to leading publications by Citywire, and the Institute of Directors, and over the years has been quoted in the Sunday Times, Mail on Sunday, The Independent, and Bloomberg Markets.
With over 25 years wealth management experience, Austyn lives with his wife and children, Black Labrador and Springer, in Beaconsfield, Bucks.
Research Sources: Bloomberg, Financial Times, Wall Street Journal, John Authers, Robert Schiller.