Performance round up
After the promising first half markets experienced a difficult 3rd quarter as mounting evidence of deterioration in China’s economy affected sentiment around the globe. Most of the falls occurred in August following the unexpected devaluation of the Chinese currency and further cuts in interest rates by the Peoples Bank of China (POBC). On 24 August, the domestic Chinese stock market suffered its biggest one-day fall for eight years, triggering a sell-off in global markets.
Other Asian markets were among the worst performers due to their trading proximity to China. Emerging Markets were generally affected more than their developed counterparts, with the FTSE Emerging Markets index losing over a quarter of its value over the period. Resource dependent countries such as Brazil have been badly hit. Oil and commodity producers are a significant component of the FTSE 100 index and have contributed to its poor performance relative to the FTSE 250 and FTSE Smaller companies indices.
Key events of the quarter
In July markets edged up on relief that European politicians had found a solution, albeit temporary, to the crisis in Greece. However, as the quarter progressed this was super-ceded by the deteriorating picture in China, compounded by uncertainty over the direction of US interest rates and the potential knock on effect on corporate earnings. Consequently the International Monetary Fund (IMF) has downgraded its forecast for global growth to 3.3% for 2015.
Another outcome of weaker demand from China was a continued decline in oil and commodity prices. Although good news for manufacturer’s input prices and consumer’s petrol and heating bills this has pushed inflation to abnormally low levels. This contributed to the UK recording CPI inflation of close to zero over the quarter while in the Eurozone and Japan it slipped back in to negative territory.
There have been several attempts by markets to stage a rally over the last month and confidence was boosted when China’s Ministry of Finance promised to carry out ‘stronger pro-active fiscal policy to stimulate growth’. Japan, which had been hit by its perceived reliance on trade with China, soared nearly 8% following this statement.
Another unsettling factor on the corporate front was the news that leading German car manufacturer VW has been found to have falsified emissions data tests. This led to a 40% decline in the company’s share price and there are fears that they may not be the only company to be at fault. This illustrates that even well respected companies can trip up and reminds us of the importance of a well diversified portfolio.
Economic trends and outlook around the globe
UK GDP growth accelerated in Q2 to 2.7% year on year with exporters reporting their best growth in 9 years despite sterling’s strength. However, the IMF downgraded its estimate for 2015 growth to 2.4% from 2.7%.
Consumer confidence in the UK hit a 15 year high in August on the back of rising house prices, improved employment growth prospects, low oil prices and low interest rates. Consumer spending remained healthy, although it slipped back a little in September, assisted by higher wage growth.
Growth and employment data would seem to support higher interest rates yet the Bank of England held the base rate at 0.5% and halved its inflation forecast to 0.3% for 2015 due to the uncertain outlook.
The US had appeared on track to raise interest rates this year after GDP growth, underpinned by robust consumer spending , was revised upwards to 3.9% annualized for the second quarter, much stronger than the initial estimate of 2.3%. The positive implications for global growth led stock markets, along with the oil price, to stage a sharp rally.
However, much of the gains were not sustained and the Federal Reserve held interest rates at record lows as concerns over China overshadowed the evidence of a firm domestic recovery. Meanwhile, the IMF downgraded its estimates for US GDP growth to 2.5% for 2015 and 3.0% for 2016.
Eurozone growth in the second quarter of 2015 was positive but sluggish. Germany continues to be the main driver of growth while the other two major economies – France and Italy – fared less well. Germany makes up nearly a third of the Eurozone’s economic output and, despite the slowdown in China, continues to benefit from strong exports.
The earnings season has overall been quite upbeat across Europe as many companies benefit from the weak euro and lower commodity prices. The ongoing quantitative easing programme has assisted the flow of credit to businesses.
The S&P ratings agency upgraded its GDP growth forecasts for the Eurozone to 1.6% in 2015 followed by 1.9% in 2016 although the IMF forecasts are more cautious at 1.5% and 1.7% respectively.
Meanwhile, the ECB (European Central Bank) left its rate unchanged, and expressed a willingness to extend its QE programme if necessary. The ECB President Mario Draghi recently admitted that further downside risks to growth and inflation have arisen due to slow growth in Emerging Markets, a strong euro and the low oil price.
Japan suffered from its proximity to China and profit taking after a strong first half performance. Nevertheless, Prime Minister Shinzo Abe has publicly pledged to expand the country’s output by 22% as a result of his reform programme comprising the “three arrows” strategy of fiscal stimulus, monetary easing and structural reforms.
The second arrow is ongoing while the third is starting to take effect with companies engaging more with shareholders, paying dividends and being more transparent about activities. This has forced management to consider return on equity and put cash on balance sheets to better use. Japan’s economy is also receiving a boost from a growing tourist trade, particularly from China, which is boosting consumer-focused businesses.
Japan actually saw a fall in GDP in Q2 of 1.2 % year on year following upwardly revised growth of 4.5% in the first quarter. This may reflect lower demand from China and a stronger yen which hurt exports. Japan also fell back into deflation as weak energy prices cancelled out stronger domestic inflation and wages data showed some retracement from the gains earlier this year.
Trade data from China indicated the economy fared worse than expected in August, with imports down over 14% in August, increasing fears of a ripple effect to developed economies. A closely followed gauge of manufacturing activity slid to a six-year low in September. Current estimates for GDP growth this year range from 4% (Citigroup), to the official government figure of 7%. The PBOC cut its main interest rate to 4.6%, the 5th reduction since November, in an attempt to boost the flagging economy.
However, it should be remembered that Emerging Markets are a disparate group. Worse affected are the commodity producers such as Brazil which has had its sovereign debt rating recently downgraded to BB+ or “junk’’ status by the S&P ratings agency which also forecasts a fall in GDP of 2.5% this year.
On the other hand, Emerging Markets are actually net importers of commodities and some are benefiting from the lower prices. For example India, while not immune from the turmoil in Emerging Markets, is set to overtake China in terms of real GDP growth and grow faster over the next decade. It is a major beneficiary of low oil prices, has favourable demographics and is seeing strong growth in financial services, infrastructure and healthcare.
Conclusion and outlook for markets
We have seen that downgrades to global growth have largely been driven by the slowdown in Emerging Markets while the US and UK economies remain relatively healthy and Europe is on a firming trend. The Bank of England and the Federal Reserve face the dilemma of strong jobs growth, low productivity and low inflation which make it difficult to determine the timing and pace of interest rate rises. Moreover, the Chairman of the Federal Reserve has stated that problems in China and other Emerging Markets were ‘a significant influence’ on its decision not to raise interest rates in September.
It cannot be denied that a number of risks remain. Even if China’s slowdown has a relatively modest direct impact on any single country, the combined effect could be significant; moreover, current forecasts are underpinned by the service economy which has so far held up.
The Institute of International Finance has warned that capital flows for Emerging Markets could turn negative for the first time since the 1980s if a forthcoming rise in US interest rates draws capital seeking a safe haven away from struggling economies. Meanwhile Emerging Market governments will find it more expensive to service dollar denominated debts which have already escalated due to the strength of the dollar.
Markets dislike uncertainty and the lack of clarity and mixed economic news is increasing volatility as markets react strongly up or down to news flow on a daily basis. However, valuations have come back to levels where they now offer better value on a selective basis. Forward price earnings ratios in Europe, the US and UK are not cheap, but have fallen back to their long-term average. There are also some very attractive dividend yields available from income stocks, many in excess of 4%. While there is no guarantee dividends will be maintained if trading deteriorates many shares are already discounting a dividend cut.
The indiscriminate sell off that has occurred will undoubtedly produce attractive entry points for purchases of quality companies and some leading UK fund managers have been buying at current levels. It may however be prudent to seek funds with a domestic bias and a cautious strategy. Areas that are holding up well are domestically based smaller companies, which are less reliant on exports, in developed economies such as UK and US where strong wages rise and subdued inflation is boosting consumer spending.
Emerging markets remain a higher risk asset class and should only be considered as part of a diversified portfolio. Weak global demand and a supply overhang are likely to keep commodity prices under pressure so in more risky sectors such as China, natural resources and Latin America there could be further downside. Investors looking to take advantage of depressed prices in these areas may wish to pick a well respected Emerging Markets fund which rotates between the best opportunities at any one time. Rather than trying to call the bottom in markets drip feeding money into a fund may be the most sensible strategy.
: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.