Steward Wealth monthly review August 2015
“Sell in May and go away,
And don’t come back ‘til St Leger’s day.”
So goes one of the best known financial market aphorisms, and this year it turned out to be quite prophetic. While St Leger’s day is still a week or so away the local market has fallen more than 10% since the start of May, the U.S. is down 6% and emerging markets by 16% (interestingly Europe is essentially flat). August saw most of that damage done, as you can see from the table above, with volatility roaring back to life and a good old fashioned correction.
Why the big falls?
As we wrote last week, there was a bunch of reasons put forward for the sharp selloff of the last week or two, none of which on their own were particularly convincing:
- China’s economy slowing down – we’ve known for ages that a $10tn economy can’t keep growing at 10% p.a. and the transition toward a more consumer-based economy will see a slowing.
- China’s devaluation – a total of 4.5% is hardly earth shattering stuff, especially after having appreciated by 20% in the past five years, and is in fact a fraction of the devaluations we’ve seen from the Euro and Yen over the past two years, let alone the Swiss Franc which fell 20% in a day.
- China’s manufacturing survey – came in at a six year low, but I bet you didn’t see any articles pointing out that the services survey, which now accounts for 48% of the economy compared with 43% for manufacturing, was at an eleven month high.
- Commodities prices at the lowest since the GFC – bad news for commodity-dependent economies (including Australia) but great news for those that are commodity importers. A 10% fall in the oil price is estimated to add 1.5% to Eurozone GDP growth. Also, given commodity prices have been falling since April 2011 it’s nothing new.
- Emerging market economies – there are a few that have seen a sharp economic slowdown, mainly the oil exporters, but others are doing alright.
- US. about to raise interest rates – the Fed has been telling us they intend to do that since they stopped quantitative easing last October.
The simple fact is the market had had a record run of 46 months without a significant correction of more than 10%. It had been going up despite all the reasons above but at some point investors stop and ask if valuations reflect what’s happening. There doesn’t appear to be any major structural imbalances like we saw prior to the GFC, which suggests the selloff is valuation-driven and markets will turn around once the right support level has been found.
For heaven’s sake, sit there and do nothing
Where is that level and how long will it take? No one can answer those questions with absolute confidence. What we can do, however, is work out whether markets offer value on a long-term basis and indeed they do and while market turbulence like this is unsettling, it should not be allowed to derail your investment strategy.
Every year the DALBAR group out of the U.S. calculates the average annual returns investors make compared to the market. This year they found that over the past 30 years the average equities investor has made 3.79% p.a. while the S&P500 has returned 11.06% p.a. and for bonds it’s 0.72% p.a. compared to 7.36%. The difference is attributed to the average investor trying to beat the market by timing their entry and exit, something that is almost impossibly difficult to do consistently and accurately.
This is shown brilliantly in the chart below. The green bars are net cash flows: money coming into the U.S. equities market and being taken out, and the brown line is the total return of the S&P500. What it illustrates is that almost invariably investors are still taking money out of the market well after it has bottomed.
Retail investors tend to make the wrong move at the wrong time
Source: Investment Company Institute
An interesting point is that the Dow Jones fell by more than 1,000 points in the first hour of last Monday’s trading, something that’s not happened before. That sharp rise in volatility is at least partly due to the computer-generated trading that now apparently accounts for more than half the daily turnover. Several High Frequency Trading (HFT) firms, that make their money through little more than institutionalised front running, said that day was one of their most profitable ever!
China – will the government ride to the rescue again?
During August the Chinese stock market continued to surrender to the inexorable pull of gravity, and has now fallen 40% from its highs. Mind you, that’s after it had risen 150% in 18 months. We wrote about the correction here. Interestingly, Chinese equities now look very cheap (see the chart below) with the overall market now trading on a forward PE of just 8.4x (compared to the U.S. on 17.4x).
China’s stock market looks cheap
Source: Bloomberg, MSCI, Deutsche Bank
Some commentators claim the global stock markets have been shaken by the Chinese market correction, but the Shanghai Composite Index actually has very little to do with Chinese GDP. Something that’s way more economically significant is that the country’s disposable income has been growing at a double-digit rate for more than a decade and factories are now paying more than 100,000 yuan ($21,000) in annual wages to skilled workers; thus the transition to a consumer-based economy.
Nevertheless, the government appears intent on stimulating the economy. After exports in July fell 8% compared with last year, they issued more than U.S.$160bn of bonds to fund construction. The currency devaluation will help a bit but it’s hard to argue such a small move will do much to stimulate exports, it really seems to be more about sucking up to the IMF so the Renminbi is included in the basket of currencies for Special Drawing Rights. The central bank also cut interest rates for the fifth time in nine months to 4.6% and lowered restrictions on bank lending and term deposits, plus they still sit on some U.S.$3.7tn in foreign reserves, which is a fair old buffer.
Global growth – a mixed bag
Six months ago we argued that global growth is likely to be lower than what we’ve been accustomed to over the past couple of decades and that inflation is also likely to stay low.
During the month the EU announced its ninth straight quarter of GDP growth, but could still only muster 1.2% p.a. (with Germany at 1.6% and France at 1%), which is actually the highest in four years. Japan’s growth rate was -1.6%, which sounds pretty bad but you need to remember Japan’s population is shrinking. When you look at growth on a productivity per capita basis real output per worker has risen 25% in the last 15 years – far better than the U.S. and Australia.
The U.S. was a bit of an exception with second quarter growth coming in at 3.7% p.a., but that was after being revised up from 1.4% – it’s hard to imagine how the first number was so wrong. Unlike the EU and Japan, U.S. exports to China account for less than 1% of GDP, so they are nowhere near as affected by China’s slowdown.
Interestingly inflation remains very low, with core CPI stuck at about 1% in the U.K. and Europe and only a smidge higher in the U.S. Central banks remain very wary of the risk of deflation, with the Fed still nominating it as one factor that might stop them pulling the trigger in September.
Emerging markets – no, it’s not 1998 all over again
Emerging market (EM) currencies have taken a real beating over the past few months. Capital flooded into those economies when quantitative easing was at its height and when capital goes into an economy it has to buy the local currency, so it pushed the price higher. But then the market became concerned all that capital would come out again chasing higher U.S. interest rates, and so the currencies have been sold. The chart below is a basket of EM currencies which has fallen against the U.S.$ by 17% over the past year alone.
Basket of EM currencies vs. the U.S.$
There has been some concern that we could see a repeat of the Asian currency crisis of 1998, but we’re far from it. Back then many EM countries pegged their currency to the U.S.$ and as capital flowed out they were forced to try to keep buying their own currency to maintain parity. Needless to say they ran out of money and the currencies tumbled. Nowadays, those same countries have free floating exchange rates – probably much to the disappointment of George Soros. In fact, one global bond fund manager described EM currencies as “the trade of a lifetime”.
Australia – when big banks can be a problem
Australia’s reporting season was partially overshadowed by the volatility on global share markets. Overall the number of companies that beat market forecasts was in line with historical averages, but the proportion of companies whose earnings were revised downwards was a bit higher than normal. Much of that comes from the ever-shrinking resources sector, which is most certainly feeling the effects of China’s economic slowdown reducing the growth in commodities demand. The chart below shows why: China accounts for a staggeringly high proportion of global commodities consumption. It’s not that demand is suddenly going to disappear, it’s just that the growth in that demand isn’t what it used to be.
China’s share of global commodities consumption
Source: Merrill Lynch
Our market also suffered from the banks falling by more than 11% over the month, something we wrote about here. A few years ago when banks represented about 20% of the ASX200 that wouldn’t have had the same impact, but now that they’re almost 40%, it has a pronounced effect.
Growth in residential investment lending in June hit 11% year on year, which was more than APRA’s line in the sand of 10%. It would have been interesting to know what was said behind closed doors, because every major bank announced cuts in their investment lending budgets and price increases. In July, growth fell to 6% year on year. There are two ways to slow growth in the housing market: raise the price of money, or reduce the supply of money. Clearly APRA and the Reserve Bank are trying to engineer a soft landing for Australia’s residential housing sector; it will be interesting to see if they manage it.
By James Weir
This article is provided for general information purposes only. It is not to be considered as advice, either general or personal.
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