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Rising risks

Even after the recent recovery, the global equity benchmark index is still down over 6 per cent year-to-date.
Wednesday, March 2, 2016 - 05:50

GLOBAL equity markets have clearly started the year on a weak footing. Even after the recent recovery, the global equity benchmark index is still down over 6 per cent year-to-date. There have been many factors at work, including weaker oil prices, increased concerns about the Chinese economic and currency outlook, weakness in Europe's banking sector and the efficacy of negative interest rates in Europe and Japan. However, the rising risk of a US economic recession has taken centre stage.

At the end of last year, we suggested a 15-20 per cent probability of a US recession in 2016. On the surface, not a lot appears to have changed. While economists have significantly downgraded US growth expectations to 2.2 per cent from 2.5 per cent since the end of 2015, not one of the 74 surveyed by Bloomberg is predicting negative growth in 2016.

Unfortunately, economists do not have a strong track record of predicting recessions. Nobel Laureate economist Paul Samuelson famously quipped that the equity market had forecast nine out of the last five recessions. The retort was self-deprecating, given that most economists had predicted none of them, leaving Mr Stock Market to boast of a much better track record.

With that in mind, once we expand the potential indicators of recession to financial market variables, the picture starts looks less reassuring: global equities were down over 20 per cent from their April 2015 peak at one point earlier this year; corporate earnings expectations have fallen sharply; commodities have continued to slump, albeit largely driven by strong supply, rather than a contraction in demand; and the premium on corporate bonds has widened significantly.

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These factors are at least consistent with economic weakness and could even undermine growth going forward should they reduce the private sector's access to credit, and dampen business and consumer confidence.

The true state of the US economy may lie somewhere between the sanguine forecasts from economists and the deteriorating financial market indicators. While our central scenario is that we are some way from the end of the business and economic cycle, the risks of a recession in the next 12 months have clearly increased to around a one-in-three probability.

Then there is the risk of China having a hard landing. Such an outcome would have a major deflationary impact on the world as China would have to substantially ease policy, even perhaps by substantially depreciating its currency.

China's economy has clearly continued to slow down despite significant boost in government spending, bank lending and monetary stimulus over the past year. However, there may a light at the end of the tunnel - reforms to rebalance the economy towards consumption, and away from investment and exports, have started to deliver results. Last year, for the first time since China embarked on its industrialisation programme in the 1980s, the services sector accounted for more than half the economy. Growth in this sector is rising at an 8 per cent clip annually.

However, one of the toughest challenges facing policymakers in Beijing today is the continued capital outflows. The outflows are putting pressure on the currency, forcing authorities to spend foreign exchange reserves to stabilise it. China's foreign exchange reserves fell US$700 billion last year, bring the total to US$3.3 trillion. This is still an impressive stash - but only as long as the current pace of capital outflows is stemmed. This is why we expect the authorities to tighten capital controls further.

Piecemeal efforts such as these are being implemented across several economies to restore growth and ward off deflationary pressures. This is notable in Japan and Europe where central banks have cut some benchmark interest rates to negative. However, investors have started to question the effectiveness of such policies, given that years of easy money policies across the developed economies have failed to lift growth and inflation back to pre-recession norms.

Given the rising risks, we believe that a coordinated and credible global policy response from an international platform such as the G-7 or G-20 would be positive, especially for equity markets. However, there are few signs of this so far.

What does this mean for investors? On balance, we still expect positive equity market returns with modest earnings growth this year, especially in the euro area and Japan. However, uncertainty has increased, especially with equities appearing to have discounted a recession less than many other asset classes.

A time-tested way to shield investments from rising risks is a diversified basket of assets. From this perspective, we are focusing more on lower volatility, relative strategies. Our preferred asset class is alternative strategies, where a lot of the factors driving performance are supportive.

High quality bonds also offer a safe haven in this environment. Within this space, we have a preference for US corporate bonds. US high-yield bonds are factoring in extreme pessimism - they are expected to generate positive returns despite an increase in corporate defaults. Meanwhile, US investment grade bonds appear to be pricing in a recession, which makes valuations attractive, in our opinion.

The other factors to watch are the US dollar strength and yuan weakness. These are seen as being negative for risk assets. A change in these trends would likely be positive, especially for emerging economies, which have borne the brunt of the market downturn in recent years.

We expect the US dollar's rally to be less pronounced, less prolonged and less broad-based in 2016. The euro may still fall against the US dollar, but we are more bearish on the Australian dollar, given our outlook for lower iron ore prices.

Oil prices remain under pressure as the market remains oversupplied, with oil inventories continuing to rise. In the short term, it would likely take a credible production cut or an escalation of conflict in an oil-producing region to push oil prices higher. The recent agreement between Saudi Arabia and Russia to cap production at current levels hardly delivers what is needed to revive prices. Over the long term, we expect demand for oil to pick up, helping oil prices to bottom in the US$25-30 per barrel area over the next three to six months. That, along with a turn of the US dollar, could revive risk-taking in financial markets once again.

  • The writer is Chief Investment Strategist at Standard Chartered Bank's Wealth Management unit
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