January was a great month to demonstrate the benefits of a diversified portfolio: equity markets around the world fell while fixed income was solid.
Commentators pointed to various reasons for the markets’ performance, the most popular of which were oil and China. As always, we caution clients to treat media commentary with some scepticism, because invariably they like to quote ‘experts’ who try to sound like they know exactly what’s going on, when the reality is that nobody can really tell you that.
With regard to oil, we wrote in some detail about that last week. Suffice to say there are a lot of producers that are losing money at the current oil price, so we can expect an eventual supply response. For now, I noticed you can buy unleaded petrol for less than $1/litre, so make the most of it while it lasts. As for energy companies defaulting on loans and dragging down the rest of the economy, whilst there is some risk of that it appears unlikely.
That hasn’t stopped U.S. banks being pummelled, dropping about 40% on fears that they will once again be the epicentre of a loan crisis. Back in 2006 housing loans represented about one third of U.S. banks’ loan books, whereas energy loans are only about 2-4% at the moment, with much of them being investment grade loans that have an even lower likelihood of default. That may have spread to the Australian banks, which are now trading at multiyear discounts to the overall market’s price to earnings ratio – see the chart below.
Australia’s major banks are trading at multi year lows
compared with the other industrial stocks
Source: Deutsche Bank, IRESS
We’ve written many times about China’s transition away from being economically dependent on manufacturing toward a more developed, tertiary type of economy where consumption and services play a much larger role. Unfortunately it seems most of the world still sees China as a giant factory and during January markets became focused on the Shanghai Stock Index as an indicator of the nation’s economic health, which is just not the case. The composition of the Chinese share index bears very little relationship to the actual economy, and as counter intuitive as it seems, there is actually no long-term correlation whatsoever between a country’s GDP growth and its stock market – that’s not just for China but all countries.
China’s central bank, the PBOC, is undertaking a massive program to reduce the overall interest that the various levels of government pays as well as manage banking liquidity. Whilst there are issues about an obvious lack of transparency, overall China has done a remarkable job in managing its economy over the past 30 years and not having to worry about minor details like being voted back into power means they have monetary and fiscal policy tools at their disposal that other (western) central banks can only dream about.
As usual, Central Banks were not far from the limelight. The U.S. Federal Reserve released its commentary and said they will be “closely monitoring global economic and financial developments”: Fed speak for we’re still going to play things very cautiously. With US GDP slowing in the final quarter plus pressures on international growth, it’s little wonder the markets are now pricing in the likelihood of a March interest rate rise at 14%.
The Bank of Japan also chimed in by cutting the interest rate they pay banks on excess reserves. Whereas previously they paid the banks 0.1% p.a. they now charge them 0.1%. What’s the point? They’re trying to encourage the banks to lend the money instead of sitting on it, all in an effort to get the economy turning over.
All in all an ugly start to the year for equities markets, but as we’ve said before, there is absolutely no correlation whatsoever between how a market starts the year and how it finishes, and on average every second year experiences a more than 10% pullback but the long-term average total return is still 10%.