2016 off to a turbulent start
A turbulent start to a volatile year
Global markets had a very difficult start to 2016, with equity markets experiencing one of the largest January falls in history, currency markets also seeing major disruption, and a sharp widening of spreads on high yield corporate bonds. By the end of the month, though, there were signs that a rebound was underway. Although the magnitude of the sell-off was clearly a concern, these developments are not out of line with our core scenario. We expected elevated market volatility in 2016 and, in an environment of subdued returns, called for an active tactical approach in order to profit from market moves. This strategy has been behind changes in the asset allocation in recent months.
It is important to understand what has driven the turmoil. We identified four main factors behind the sell-off:
- Monetary policy running out of steam. The Fed lacks a clear model following the end of quantitative easing (QE), which creates uncertainty, and other central banks’ QE is too weak to sustain financial markets. As a result, central banks’ ability to repress financial volatility has decreased.
- The fall in commodities prices. Although lower oil prices benefit consumers, prices have dropped below the threshold (probably around USD40/b) where the negatives in terms of financial disruption start to outweigh the positives. EM currencies have slumped, especially for commodity-producers, creating the risk of a financial crisis, most notably in Brazil (as outlined in this edition’s ‘Topic of the Month’). And oil companies’ difficulties have pushed up US high-yield spreads sharply.
- Concerns about China. Moves towards liberalisation of equity and currency markets have proven somewhat messy, with a crash in Chinese equities and considerable pressure on the yuan. The Chinese authorities have the capacity to sustain economic growth at the targeted level, but their management of financial markets has been poor.
- The strengthening US dollar, which is putting pressure on the US manufacturing sector and emerging-market borrowers in USD. However, economic fundamentals remain reasonably healthy – albeit lacking in momentum. The US remains on course for real GDP growth of 2.0% this year, and the euro area for a slight acceleration to growth of 1.8%. Our forecast for real GDP growth of 6.7% in China also remains unchanged. Concerns about a US recession look overblown. Accordingly, we did not think that the sell-off was the start of a major financial crash – although the magnitude of the corrections means that the risks of such a scenario have risen.
Rather, as we expected, a rebound now appears to be under way. Internal market dynamics suggested that conditions were ripe for this, and central banks seem to have provided the trigger that markets were looking for: the European Central Bank (ECB) indicated that it would loosen policy further, probably as soon as March; the Bank of Japan (BoJ) unexpectedly cut rates into negative territory, and the People’s Bank of China (PBoC) is providing fresh liquidity injections to support growth. Although we do not expect the US Fed to change course on raising interest rates, it at least expressed concern about the implications of developments for risks to the outlook. In addition, oil prices may have found a floor. The oil price rebounded from a low of USD28/barrel on 20 January to approaching the mid-30s by the end of the month.
Our core scenario therefore continues to hold. As we have explained previously, this year will be characterised by a lack of momentum in economic growth and in growth of corporate earnings. Concerns around central bank policy and China are unlikely to dissipate completely; the supply glut in the oil market will limit the rebound in the oil price; finally, the USD bull market is not yet over, even if it has largely played out.Our asset allocation has developed accordingly, and has proven well adapted to the new environment. US Treasuries have performed their role of portfolio protection well, and we have made timely tactical changes to our equities allocation in anticipation of market moves. Developments in January are just the opening chapter in what is likely to be an eventual year on markets. We will continue to work to anticipate the twists and turns in the story, and respond in a timely fashion.
Volatility is therefore likely to remain high. The recent sell-off on equity markets was the second drawdown of over 10% in the space of barely six months, suggesting that the period of low volatility that had characterised equity markets since 2011 is now firmly over. Weak expected returns and higher volatility will mean a key role for active tactical asset allocation and stock-picking.