Market Perspectives - Quarter 1 2016


Highlights

• Stock markets fell sharply in Q1 mainly due to volatile commodity prices and weakening Chinese growth.

• Central banks worldwide have been very active in trying to cushion the shock; the European Central Bank (ECB) and Bank of Japan (BoJ) deployed negative interest rates and further eased their monetary policies, whilst the US FED delayed the interest rate hike.

• The reversal of the negative trend happened in the middle of the quarter, markets picked up strongly and some of them ended at broadly similar levels to the beginning of the year.

Market Commentary Q1
Markets have been following a downward spiral right from the beginning of the year till mid-February, and the sell-off was triggered mainly by two factors - decreasing and volatile commodity prices, oil in particular, and slowing growth in China. These issues in fact have been passed on from 2015, but they gained much more strength and proved to be the cause of some of the sharpest Q1 falls in the recent history of equity markets.

In February, the price of crude oil fell to its lowest level since 2003, and since the peak in June 2014 at $108 it lost an incredible 75% to close at $26. The steady decline created a widespread headache for financial markets and we have witnessed a rather interesting strong short-term correlation of oil price and equities. Both developed and emerging markets around the world were tumbling as a result of nervousness due to the plunging profits of energy companies and worries about another recession around the corner, even in sound economies that would actually benefit from cheaper commodities. Another major factor explaining the anxiety amongst investors in the early part of the quarter was the Chinese financial markets. January was a particularly tough month and Shanghai and Shenzhen markets tanked 24% and 27% respectively. The initial trigger was lower GDP growth estimates announced back in 2015, however such a dramatic change in the sentiment that we have seen afterwards, is mainly the result of panic and herding behaviour which characterises this still inexperienced market, coupled with government interventions (the so called circuit breakers which imposed a trading halt), which have not been particularly efficient. Since the highest point in June 2015 to the end of Q1 the main index lost 45%.

In the second part of the quarter the sentiment changed and we have seen a turnaround of the situation and a recovery in stock markets, bringing some of them to levels broadly comparable to the start of the year. The rally was triggered by a stabilisation of US economic data, the rebound in the oil price as the market anticipated that supply and demand would rebalance by mid-year, reflationary policies in China, and the Bank of Japan (BoJ) and European Central Bank (ECB) finding new tools to try and stimulate the sluggish growth.

Market Outlook
After the latest re-pricing in the markets worldwide there are both opportunities and further risks.

The most likely upside surprise is a pick-up in US consumption, driven by wage growth, cheaper energy prices, and mortgage refinancing. On top of that we saw a continuation of loose monetary policy by ECB and BoJ with a goal of doing “whatever it takes” to beat deflation. Back in January, the BoJ moved into negative interest rate territory. The ECB, which had already deployed an unconventional monetary tool of negative interest rates, further enlarged the size of quantitative easing (QE) and decreased its main lending rates further. Although there is a heated debate about the efficiency of such monetary tools, investors broadly agree on the fact that this will provide a short-term support for asset values. We find these measures as very supportive and they could lead to a rally in developed equities, especially in Europe. In terms of valuations, Eurozone equities are trading at a discount of 18% to its US counterpart, so should the stimulus work we see an upside potential in this subclass.
For now the two main drivers of sharp downward movements in the last quarter have stabilised to an extent. The price of oil which was the main trigger of volatility in Q1 is now positioned at around $40 and this has consequently made movements in emerging market equities more positive. China has shifted toward stimulus in order to avoid a sharp slowdown, which has been well received by the markets. Besides this market has already been severely punished by losing 40% of its value from the highest point in June last year.

In terms of the downside risks, there is still a threat of the world economy tipping into recession. The cause could be a combination of factors including credit problems in emerging markets, especially China; a re-emergence of the Eurozone debt crisis; 
political crisis in the US in light of presidential elections; Brexit and the EU crisis, to name but a few. In terms of the latter, whatever the result of the UK referendum will be, the stock market and more importantly Pound Sterling are expected to go through a prolonged period of volatility. A vote for leaving the EU would most likely lead to a sell-off of UK assets in the short term and uncertainty in terms of the trade agreements, movements of labour and capital, etc. which would hurt the economy. Europe would not be unaffected in this scenario either.


In summary, global growth is likely to continue to be anaemic. Some of the main drivers of Q1 volatility have stabilised but markets are still fragile and positive investor sentiment that we have experienced in the past weeks could change quickly again. The rest of 2016 will most likely be characterised by more volatility, but modest returns are achievable through careful asset selection. In terms of positioning in the current environment, we are optimistic about developed market equities and defensive sectors. We continue to prefer European equities over US ones as they still remain relatively cheap, offering good value, and are supported by the expansive monetary policy. Emerging market equities have its place in our portfolios but we look for fund managers who put active weight on high quality stocks in regions such as Asia-Pacific (e.g. India and Vietnam); we avoid funds with heavy exposure to commodity-dependant economies. Unconventional policies deployed by central banks brought bond yields to the bottom and holding government bonds does not offer much return. Bonds will therefore take only small part of our portfolios and will be partially substituted by absolute return funds and other assets in the alternative space, which offer better diversification and protect portfolios during downturns.

Region/ Asset Class

Index

To March 31th 2016

Month

Q1/YTD

Global Equity

MSCI World

5.27%

-1.96%

Europe

MSCI Europe

1.92%

-4.92%

Japan

Nikkei 225

4.57%

-11.95%

Emerging Markets

MSCI EM IMI

8.33%

2.74%

United States

S&P 500

6.73%

1.18%

United Kingdom

FTSE All Share

1.94%

-0.41%

Global Bond

Barclays Global Aggregate

2.70%

5.90%

Gold

S&P GSCI Gold

0.03%

16.49%

*Gross return, local currency. Source: FE Analytics.