Stockmarkets, as measured by the MSCI World Index, are down 8% from the May highs and flat on the year, with government bond yields back on the downward path. Many commodity prices have fallen back but we still face significant upside inflationary risk from food prices if climate conditions deteriorate further.
Stockmarkets have seen a shift from cyclically sensitive sectors into more defensive areas with the best performing global sectors year to date being healthcare equipment and tobacco, both up 11%. The biggest losers have been leisure goods and industrial metals down 15% and 12% respectively and earnings momentum is weak compared to where it was following the Q2 earnings season.
Rationality
Despite all this bad news, the consensus view remains that this is a soft patch and that growth numbers will pick up in the second half of the year. Is this a rational assumption?
I said in March that equity valuations looked attractive but that we would experience volatility in the short term; I have been proven correct on the volatility front with the market now back at the levels we were at in March – having been 8% higher in the meantime!
On a second and far more important point, I still think equities are good value on a variety of different measures, including cyclically adjusted ones, and relative to other asset classes. They remain my favoured asset class.
As investment strategists we are faced with a number of fundamental problems, one being the lack of correlation between equity returns and economic growth, particularly in developed markets. This may seem like heresy to many. Admittedly, in some periods over the past three years, macro surprises have resulted in significant moves in equities. However, over longer periods the correlation between them is limited. So, if we cannot rely on economic activity data to determine future equity market movements what are the main drivers?
As with most problems there is no one simple answer. However, there are two factors that do have positive correlations with returns; they are valuations and liquidity.
Multi-asset consideration
These are absolutely critical, not just for equities but for all asset classes. By analysing these factors on a global and regional basis it is possible to assess whether or not a particular investment strategy should be deployed at a particular time. Valuations must be done at a company specific level, as we invest in companies not markets, and liquidity can be assessed by statistical analysis of publically available data. Only this will determine investment success over the long term.
For what it is worth I agree with the consensus and think that the current data is consistent with a mid-cycle slowdown. Also, if we look at some of the economic data that has been ignored there is another side to the economic argument that may have an effect on markets.
Firstly, inflation is well below the level at which equities will tend to react negatively. Secondly there are more people in employment now than there were prior to the economic crisis and not only are they spending more per head but there are no significant wage pressures, which is a key inflationary component. Finally, global levels of liquidity remain high.
As well as all this, perhaps most importantly, corporate balance sheets are, in many cases, as strong as they have been for decades and valuations are not demanding. Clearly earnings over the second part of the year will be critical and will depend somewhat on our central scenario being correct. In terms of portfolio construction quality is the key.
I will close with a quote, a reminder of Winston Churchill’s comment: “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty”.
