Equities and credit have corrected sharply so far this year, with safe haven bonds, USD and JPY benefiting. While we believe that some of the fears about the global economic outlook are overdone, the uncertainty surrounding that outlook keeps us from adding to risk exposure at this stage. We think markets are likely to remain volatile for now and we continue to actively manage risk exposure within each asset class. A consistent preference for developed markets over emerging markets across equity, credit and currency markets should help manage the short term risks and bridge the transition to a more positive medium-term outlook.
An unwelcome start to the year
Markets have corrected sharply since the start of the year, driven by a number of factors (as discussed in our market commentaries from 7 and 15 January). Some of those factors are related to economic fundamentals, while others are based on fears or uncertainty. Some seem reasonable, while others may be exaggerated. And some may be temporary, while others may stay with us for longer. We think it is important to make these assessments to determine how to react to the current market volatility.
The first and most important driver of market volatility is the pessimism related to the economic outlook in China. Weakness in the data is not new, especially in the areas of manufacturing and trade. To this extent, it seems odd that recent economic data points have had such a significant impact, especially as some areas of the Chinese economy are resilient, with good growth in consumption and a tentative improvement in the property market. As we discussed in our quarterly investment outlook, we believe that Chinese leaders have the tools to stabilise growth through monetary policy support and fiscal measures and to continue to move towards their long term plan of a more balanced economy.
However, markets worry about the many uncertainties related to the Chinese growth outlook and economic policy. While we think that rates may be cut by 0.5% and bank reserve requirements will be reduced by 4%, it is fair to question how quickly this will translate into better growth. We think the economy will only stabilise in Q2, which may imply that volatility and uncertainty are likely to continue for a while. A second area of uncertainty is related to the FX policy, where markets fear that the government may allow for more currency weakness to lift competitiveness. While we do not expect policy-driven currency weakness, this concern hurts sentiment. For now, flows and deleveraging of positions in the region not only continue to provide scope for persistent short term volatility, but are also hard to predict.
Lower oil prices have hurt risk appetite as well. Generally, oil prices can have a positive effect on consumption but they have a negative effect on investment spending (as the energy sector had in recent years expanded capacity) and on many emerging market economies (commodity exporters). However, these negative effects tend to occur quickly, while the positive effect on the consumer tends to feed through later, and in many instances has been disappointing. Therefore, this lag may imply that any further commodity price falls continue to be a negative overall in the short term, but start to add to growth later this year.
Again, investor risk appetite is also hit because of the uncertainty related to oil prices. Investors should be excused for wondering whether and when Saudi-Arabia will cut production, how much and how quickly Iran will increase its production by, and at what point US production becomes increasingly uneconomic (production costs have fallen sharply). With oil being so volatile, investors find it difficult to determine a base case for oil prices, and it is no surprise that appetite for investments related to oil remains very limited.
In summary, because of the time lags and the uncertainties, we believe that it will take some time for investors to feel comfortable that they have a clear view on Chinese growth and oil prices. Until they feel these issues are less opaque, their concerns are likely to continue to weigh on risk appetite.
Reasons to be constructive, but for the medium term
It is clear that lower commodity prices and a slowdown in China are bound to have ripple effects around the world. However, we think that some commentators have started to worry about some scenarios that we find unlikely, and that valuations in some areas of the market have started to incorporate scenarios that are too negative. These mainly relate to the developed markets.
-First, we do not believe that the risk of a global recession has significantly increased. We think that the Eurozone continues on its gradual path of improvement, with new signs of strength in the housing market, for example and increased lending activity by European banks. We have heard investors and commentators worry about a US slowdown as well, and we think that healthy job creation and mild wage growth should continue to support US consumption. When we look at the historical relationship between US or European equity market moves with economic indicators, it seems to us that overly pessimistic economic scenarios are now priced in.
-Secondly, some have started to worry that the Federal Reserve might have to stop its rate hike process already, after executing just one hike in December 2015. We disagree with this, and foresee two hikes (of 0.25% each) this year, as a result of economic improvement and the absence of a global recession.
In summary, we think that the recent correction in developed markets has created a medium-term investment opportunity for investors, as we question the validity of these fundamental concerns related to developed markets.
Bridging the gap between short-term volatility and medium-term opportunity
To manage the short term volatility which we expect to continue to see (mainly related to EM and commodity prices) and the medium-term opportunity (mainly in developed markets), we adopt the following strategy:
-We maintain our current small overweight in equity markets to remain exposed for the medium-term, but with a pronounced focus on developed markets, an underweight position in emerging markets and a defensive sector positioning overall.
-We limit our exposure to markets that are heavily correlated to commodity prices: we have almost no exposure to Latin American stocks, are underweight the basic materials sector and hold a cautious view on BRL, ZAR and RUB. We also downgrade South-African sovereign bonds and Gulf Cooperation Council (GCC) corporate bonds.
-In corporate credit, in spite of the significant widening of high yield spreads, we maintain a cautious approach for now, as spreads often spike and move in a non-linear fashion in times of volatility. We maintain our focus on BBB/BB-rated credit and remain particularly selective in energy-related US high yield names.
-We actively look for diversification, limiting concentration in single markets or single names, and using alternative assets such as hedge funds, real estate and private equity to help temper the volatility of our portfolios.
In summary, we think that risk appetite may remain fragile in the short term, before improving later in the year and providing an attractive investment opportunity at that time.
We remain invested but, in each asset class, temper exposure by focusing on quality, liquidity and diversification.
Jose A. Rasco is the Chief Investment Strategist for HSBC Private Bank-Americas. He is a member of the Global Private Bank Investment Committee. This column is for informational purposes only. It consists of general market commentary and should not be relied upon as investment advice.