The Year of the Crocodile

Marino Valensise, head of Barings’ Multi-Asset, is offering up The Year of the Crocodile as a name for 2016. 2015 has been a year of cross currents, which returned global equity markets to their starting points, he says. Global sales and earnings struggled to progress and, as a result, equities have barely changed since the beginning of the year. Neither bulls nor bears managed to win. This “ticket to nowhere” took investors on a winding path, with unusual market swings producing higher levels of volatility, he adds.

“It has also been a year of divergences, and not just in terms of global monetary policies. In fact, some key markets and economic data have also diverged. Large gaps have opened up between items which are usually correlated. The rational expectation is that something will have to give. The crocodile mouth will have to close.

“The first divergence is between high yield credit and the US equity market. A crocodile mouth has been created by the extreme and unusual gap in performance that has developed between the two, with credit performing very poorly. Is the credit market the first indication of problems to come, with equity investors being perennially over-confident? Or is credit a great buying opportunity?

“Another is the difference in economic performance between the manufacturing and non-manufacturing sectors. The gap is reaching extremely high levels and so, inevitably, something will have to give: manufacturing will need to stabilise and improve, or non-manufacturing will need to lose steam and retrace.

“Finally, there is an increased divergence in market performance between the few winners, and the many losers. Breadth in the US equity market is disappointing, with fewer large cap stocks delivering the bulk of market returns. This group of stocks is commonly defined as the “nifty nine” (Facebook, Amazon, Netflix, Google, Priceline, eBay, Starbucks, Microsoft and Salesforce). More narrowly, these are the FANG stocks (Facebook, Amazon, Netflix, Google). These are already trading at very expensive valuations and might bite downwards, unless the rest of the equity market performs better.

“As we go forward into 2016, investors will face the additional challenge of having to scale a number of peaks.

“The first is a peak in profit margins. The three pillars of the great profit margin expansions (tax expense, labour cost and interest rate cost) are ready to invert. The good news is that any dent to corporate profits will take years to materialise.

“There is also a peak in some technical factors, including margin debt, M&A (mergers & acquisitions) and share buybacks. These have been underpinning the equity bull market and are unlikely to improve from here. While margin debt peaked in 2014, time will tell whether current levels signal a top for M&A volumes and share buyback activity. Given the state of the credit market, this is a real possibility. If so, there will be a negative impact on the US equity market, though no direct implications for Europe and Japan.

“One peak which has been already reached is in liquidity. Due to new regulation, banks have slashed the amount of capital devoted to trading in certain assets, moving from a principal to an agency based business model. Hence, liquidity has been in decline for years. The seriousness of this problem is increasingly exposed as a result of the proliferation of a class of investors hungry for liquidity; mutual funds, exchange-traded funds and momentum-driven investors.

“The last is a peak in emerging market foreign exchange reserves. Markets are currently fighting a global liquidity drain    as emerging market central banks and sovereign wealth funds liquidate their financial assets to raise funding and resources for their governments. As an example, China might be liquidating some of its US dollar assets to manage the decline of the Renminbi. Globally, sovereign wealth funds and monetary authorities of oil-producing countries are disposing of liquid financial assets to meet the growing needs of their governments’ coffers.

“As a consequence,  market participants have found themselves in a state of anxiety, torn between awareness of the hazards and reluctance to sell risky assets, as there is no sign yet of an economic or profits recession.

“Ultimately, two factors will determine future returns from equities. The first is valuations. Given monetary policy developments, these are unlikely to progress further in the US, where a small compression is more likely. Instead, there is some space for improvement in European and Japanese valuations, which should still benefit from tailwinds of monetary easing.

“The second is earnings growth, perhaps a more complicated story. Our base case for 2016 is that we should experience some stabilisation in both the US dollar and the oil price. Under these assumptions, we should see earnings growth of 4 percent to 6 percent in the US, while  Europe and Japan should be able to grow profits at a pace close to 10 percent.

“Once combined, these two factors should lead to modest equity returns (3 percent to 4 percent) in the US, but a more attractive proposition in Europe and Japan, which should deliver high single-digit returns. However, we acknowledge that the risks to this scenario are increasing.

“In 2016 there is scope for investors to tactically enhance their returns by focusing on two specific issues: preference for smaller caps and a counter-rally in value stocks.

“We believe that some market participants are likely to place continued pressure on large cap equity indices. In a world where volatility is on the rise, these will be easy to sell in the event that one wanted to put in place a market hedge at short notice. Hence, large caps may continue to be subject to intensive, but irregular, waves of selling. Selecting other type of betas (i.e. mid and small caps) or alpha opportunities might benefit portfolios.

“The second point relates to a potential counter-rally in value stocks, led by the energy and materials sectors and by emerging market equities. In Asia, in particular, while we expect continued volatility, we won’t rule out asset markets doing better, underpinned by the benefits of lower energy prices, lower valuations and some early sign of stabilisation in the Chinese economy.

“We would regard this, however, as a tactical trading opportunity. The structural imbalances in the commodity space and the issues relating to many emerging economies will be slow to cure. We can’t guarantee the journey will be smooth but, if appropriately navigated, volatility will represent an opportunity as well as a risk, during 2016.”