By Nikko Asset Management Global Equity Team, Edinburgh (headed by William Low, Head of Global Equity)
Global equity markets have had a poor start to the year with deterioration in market sentiment and concerns over whether central bank actions can continue to support the global economy. This correction has not greatly surprised Nikko Asset Management’s Global Equity team given the following factors:
1. Equity risk premiums were at low levels having been artificially boosted by years of quantitative easing (QE);
2. Profit expectations had been high, both in terms of growth and scale of profitability;
3. China has raised the stakes in the global game of competitive currency devaluation; and
4. Global emerging market debt and anything energy or commodity related have proven to be a ‘busted flush’.
However, the scale and pace of declines have been severe. The deterioration in credit markets along with equities is providing a clear bearish signal to investors, which is driving a negative spiral of liquidation and unwind. This places us in a quandary since the current market phase of “selling winners” and shorting key indices/ETFs is making equity markets quite indiscriminate at the stock level.
As a result, we have a tough call (and not for the first time) to address whether this is creating a market backdrop where patience will be rewarded and just following volatility/rotation is a ‘mug’s game’, or whether a structural deflationary re-pricing of equities is taking place to force the hand of central banks to adopt further rounds of monetary inventiveness.
‘Stick tight’ thesis: what would support this strategy?
Markets have been declining for a sustained period, with the S&P 500 Index (USD) at 147 days since its peak and the MSCI AC World Index at 193 days since peak (as at 16 February). In terms of the scale of declines, the S&P 500’s fall does not look that significant versus history (see Chart 1).
Chart 1: S&P 500 Index (USD) since 1990
However, given the concentrated nature of the market in recent times, the broad equally weighted index shown in Chart 2 gives a better indication of what is being discounted in the average stock. This highlights that we are getting close to the minimum 29-37% drawdown seen in major market falls in recent decades.
Chart 2: Broad, equally weighted index (USD) since 1990
Other factors that would support this strategy are general signs of market liquidation, such as DAX (German Stock Index) volatility, high correlation across sectors, and short covering in prior leading stock fallers.
So does this mean we should be adding beta and risk exposure? If the world is likely to remain in a period of benign but slow growth with poor returns from cash and sovereigns, then equities are more than likely at the lower end of a broad trading range. In this environment, companies that are not seeing ongoing pressure on profitability should be sound investments.
Deflationary bust thesis: what would support this strategy?
There is a long-festering concern that QE is actually failing and all equities will be re-priced for ongoing deflation as the global debt mountain suffocates growth. Although we do not think a deflationary bust is imminent, we believe that the greater the probability that it will happen, the wider the trading range will be. So what are the key litmus tests for a deflationary recession?
• Main Street is affected along with Wall Street, with the end of an era of low borrowing rates and ready availability of loans for consumption purposes (e.g. auto loans).
• Job security becomes a concern for all industries (not just energy companies and Wall Street) and the threat of unemployment results in high savings rates and lower wage hikes.
• Lower gasoline prices are saved rather than spent.
If the private sector does not want to increase borrowing for productive purposes, the gravy train of refinancing balance sheets to finance buybacks and the equity packages of executives is over. As a result, financial intermediaries will focus on building capital instead of increasing balance sheets.
One indicator that is signalling deflation is the bond market (see Chart 3). .
Chart 3: US 10-year Treasury bond yields
Conclusion: Remain focused on individual stocks for now
In summary, we may be arriving at a period of selling exhaustion, with the world not quite as bad as implied by the market’s deflationary pricing. Through the current period of volatility, we are sticking with our existing portfolios but closely watching the market direction for further deflationary signals.
As a high conviction manager, our focus remains on the individual stocks and their investment thesis and the messages arising from the current reporting season.