Happy New Year to all our readers. We promised late last year that we would update our views in the new year. There is a lot to discuss and we will have to break this discussion into bite sized chunks over the next few weeks rather than bombard you with an extremely lengthy report today. As noted in our 12th December report “Some Dangerous signals appear in Financial Markets” (See here), the best that could be hoped for in 2016 was a sideways muddle through similar to 2015. We explained that our worst case scenario was “A large bear market with the dramatic declines seen this August providing a foretaste of what is to come”.
Financial markets have suffered one of the worst opening weeks on record. A lot has already been written about the causes of the sell-off in risk assets. Here is a list of market impacting events/issues, in no particular order.
- Poor Chinese business surveys, coincident with two dramatic days of selling in the equity market and concerted weakness in the currency.
- Worrying escalation in Middle East tensions with Saudi and Iran cutting off diplomatic ties.
- Further significant weakness in oil and industrial metals prices on worries over lower demand as well as continuing excess supply.
- Further strength in the US Dollar.
- Worries that the US economy is slowing down and that the Federal Reserve may have committed a policy error by raising rates in December.
- Highly regarded investors/commentators (in particular George Soros) warning of market vulnerability and even “echoes” of the Global Financial Crisis of 2008.
- Missile testing from a belligerent North Korea.
- Concerns about Apple after reports that production of iPhones will be reduced by up to 30%, presumably as inventory is building as sales fall short.
Even the decent US employment report at the end of the week failed to boost the spirits. Equity markets have suffered some of their worst “first week of the year” declines on record, credit spreads continue to widen, commodities were in freefall and FX markets had a risk off tone with the Japanese Yen the best performing currency. Over the week, US equities were down 6.0%, UK 5.3%, Europe 7.2%, Japan 7.0%, China 10% and Emerging Markets 6.8%.
Although it must feel like we have been bearish on equities forever, we have held out more positive positions from time to time during periods of QE. We did, however, become much more cautious in April last year as we saw signs of the US equity market losing momentum (see our “Equity Markets on Edge” note from 18th April HERE and our “US Equities Running on Fumes” note from 26th April HERE for examples).
Our concerns became more immediate in the early Summer as we saw gaping cracks open in Emerging Markets and signs of a very mature global and in particular US equity bull market (see our “After the glimmer of light from Greek rescue dark storm clouds are gathering” note from 25th July HERE).
As we all know, equity markets suffered a torrid late August sell off. Although the rally in October/November was much more aggressive than we thought likely, equity markets did not trade above earlier highs (except the Nasdaq 100 Index) and we have stuck to our bearish thesis. The disastrous start to trading this year is not that big a surprise to us.
The main question now is what will happen in the weeks and months ahead. Can central banks entice investors back into the “casino” that they have turned the financial markets into? Or will investors increasingly try and sell risky assets into a market place almost devoid of liquidity? Are the global deflationary forces now too strong for central banks to fight with their blunt tools?
Frankly, we agree with George Soros. Financial markets appear to be vulnerable to a bear market possibly of similar magnitude to that seen during the financial crisis. US equities are extremely overvalued and the twin props of QE and corporate share buybacks have lost a good deal of their potential power. A bear market in US equities could easily tip the US economy into recession which would impact corporate cash flows and the ability of companies to service their record debts. We expect the default rate to rise substantially in the event of a recession.
It goes without saying that a US recession would have serious repercussions for the global economy. The Emerging Markets, which are already teetering on the brink, will likely suffer a full blown crisis. In this scenario, there would be significant currency devaluations including in China and this would send further waves of deflation around the world.
So, clearly, there is a lot at stake, and the swing factor in our opinion is whether US equities fall into a bear market or not. The chart below shows the weekly chart of the S&P 500. The headline US index is now back to levels first seen in June 2014, i.e. no progress for 18 months now. Frankly, we are still not sure what forces came to bear that managed to engender such an aggressive rally in October after the vicious late August sell off. However, with the index basically flat last year and companies spending more than US$600 billion to prop up their share prices, we suggest that without such aggressive share buybacks, the market is vulnerable to another vicious sell off.
Chart 1 – Weekly S&P 500 with 55 week moving average
We do worry that the post crisis bull market, driven initially by ultra-easy monetary policy, was extended and even turbo charged by buybacks and M&A (a.k.a. financial engineering). If companies cannot issue new debt because investors are refusing to buy it, and share prices enter a bear market, management will be forced to cut spending to defend profits. This will mean reduced capex and job losses, as already seen in the energy and mining sectors. The two charts below show the long term relationship between US equities and both capex and jobless claims (as a lead indicator of the employment market).
Chart 2 – US equity market v. core capex
Chart 3 – US equity market v weekly jobless claims
As we cast around the US equity arena, many factors are also confirming the potential for a new bear market. We won’t show charts for every one of them, but the advance/decline data, new highs v. new low data, credit spreads and margin debt all indicate that there is substantial downside in US stocks this year.
If US stocks enter a new bear market, we expect most developed markets and emerging markets to decline as well. Perhaps over time, the relative attractiveness of Europe and Japan, and the fact that their central banks are still printing money, will help them outperform the US. In the shorter term, it appears that there has to be a blow up somewhere in the EM space before investors dip a toe again.
We have been warning about Emerging Markets for well over a year now, and there is nothing occurring to change our mind. In particular, commodity exposed countries are in serious difficulty with the commodity swoon continuing. Important countries like Brazil, Russia and now Saudi Arabia are in various degrees of trouble that could easily end up in full blown crisis. China has been hitting the headlines this week, again something we have written about repeatedly in recent months. The major danger is that China simply cannot stop capital fleeing the country and the Yuan continues to weaken thereby unleashing further waves of deflation upon developed countries.
Emerging market assets have been suffering for a long time now, but there is the potential for things to get worse. The chart below shows EM assets versus Global Reserves. The EM equity markets are breaking down from a big topping area and may decline substantially from here in the worst case scenario. Sovereign bond spreads are on the cusp of widening dramatically as well. With China and other EM countries now dis-gorging their massive reserves, this acts as a kind of reverse QE for these economies. We see reserves declining across the EM world assuming the trends of recent months remain place.
Chart 4 – EM equities (red) v. EM bond spreads (white & inverted) v. Global FX Reserves
We’ll leave it there for this week. As described at the beginning, the best case scenario is that markets muddle through as they did last year with bouts of volatility. The worst case scenario is a bear market in global equities and credit markets, global economic recession and an EM crisis. The signal from the first week of trading appears to support the bearish case and further declines in the next few weeks below critical support levels will only add to our conviction in the bearish case.
Needless to say, in the bearish scenario, core Government bond markets will perform well and we should expect further easing from central banks and a Federal Reserve that will be increasingly under pressure for having raised rates in December. We will update our cross asset views in the period ahead.
Stewart Richardson
Chief Investment Officer
