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Clouds over New York

Decline not fall

09 February 2016

Yesterday’s steep slip on equity markets lacked any clear trigger event, yet while fear remains dominant, short-term falls are inevitable.

It has not been an easy year so far for investors. Major stock indices are significantly down since the beginning of the year; both the S&P 500 and FTSE 100 indices are down by nearly 10% since trading began. Japan’s Nikkei 225 is down by more than 15%.

Yesterday the slide continued, with sellers focusing on European banks in particular, following announcements of disappointing earnings for both the fourth quarter and for 2015 as a whole. The FTSEurofirst 300 was the worst-hit of the major indices yesterday, falling by 3.38%. It is now down 15% since the start of the year and at a two year low.

Leading the losses were some of Europe’s largest banks. Deutsche Bank and Commerzbank both saw 9.5% shaved off their share price – meaning that at the close of trading yesterday, the former had lost 35% of its stock value over the course of 2016.

Among the chief concerns affecting bank stocks are exceptionally bad recent announcements of results, increased concerns that negative interest rates at major central banks will hit bank profitability, and the heavy exposure of banks to the falling oil price. However, these concerns did not suddenly appear on Monday morning and, in the coming months, they are likely to prove less important than the relative health of bank balance sheets.

“We have been a little surprised by the severity of the market downturn,” said Stuart Mitchell of S.W. Mitchell Capital. “The bull case is that the strongest banks – such as the Italian bank Intesa Sanpaolo, Lloyds and BNP Paribas – are now amply capitalised and able to start paying compelling dividends. I was with Carlo Messina, the CEO of Intesa, yesterday and he very confidently pointed to a 6% dividend yield this year. Loan growth is also starting to recover, and loan loss provisions are starting to fall sharply. The bears, however, have been spooked by the apparent slow-down in the US and Chinese economies, arguing that this will eventually undermine recovery in the European economy.”

The breadth of reasons being given for the latest stock downturn suggests two leading possibilities. The first is that investors are nervy and adopting a herd mentality in the face of high volatility. The second is that a more fundamental global slowdown is under way, with recession a strong possibility.

There is a strong sense that investors have been overreacting to bad news and negative market momentum in recent weeks. But it is also true that some investors are worried that the recent decline in bank stocks presages a downturn for the global economy more broadly. In short, could we see 2008-09 all over again?

“We have done much work on this, and we do not believe this to be history repeating itself,” said James de Uphaugh of Majedie Asset Management. “First, banks have spent the last eight years deleveraging their balance sheets [so that they now] more than satisfy the regulator. Second, bank shares have fallen sharply to levels that offer significant support, and substantial upside for patient investors with a long-term horizon, as we are. In our judgement, if there is a sustained downturn, banks would hold up reasonably well. It is worth looking back to 2000, when the dot.com bubble burst: the very highly valued TMT [telecoms, media & technology] stocks collapsed, but banks gave investors some protection.

“Lastly, it is worth stressing that much of the trouble banks got into in 2008-09 originated in their trading businesses. These have reduced due to concerted global regulatory action to split ‘casino’ activities from those designed to support the real economy. Whilst much of the credit goes to regulators in changing the banks, we also believe that the latest group of bank CEOs are a significant step up in quality to those they succeeded, which augurs well for the future,” suggests de Uphaugh.

Yesterday, the results of a new study conducted by Goldman Sachs were published, which showed that Britain is extremely unlikely to face an economic recession over the next two years and is on safer ground than any other country in the developed world. Jan Hatzius, Goldman Sachs chief economist, pointed to a number of past episodes – in 1987, 1994, 1998, and 2002-4 – when markets had started to price in a recession, and had been proved wrong.

The health of the Chinese economy continues to be another worry for the market bears, which has arguably replaced the US Federal Reserve as the biggest cause for concern. There is no dispute that it is slowing but, as Hugh Young of Aberdeen Asset Management points out, “Slower growth is as much by design as accident as the economy moves away from an investment-led, export-driven model towards one in which domestic consumption plays a dominant role. The country’s leaders want growth that is sustainable.”

But Young also stresses that investors need to put into context the falls seen in China’s stock markets since the start of the year that have spooked investors worldwide. “Chinese equity markets are completely divorced from reality. When share prices are driven by an interaction between state-sponsored market manipulation and the speculative instincts of millions of retail investors, they cease to serve as a gauge of a company’s quality.”

Young says the economy is nowhere near crashing. “Our fund managers speak to officials and consultants around the country and nothing has gone ‘pop’ in the economy. The stock market turmoil does an excellent job of serving as a timely reminder of the pitfalls that await complacent investors.”

Thinking long term

All the wisdom in the world, however, does not make it easy for investors to watch stock prices falling. For many short-term investors, the answer to a troubled few weeks on markets has been to exit equities and avoid the problems.

While the temptation of cash might seem greater at times like these, it will not provide the solution to longerterm investment needs of capital growth and rising income.

Latest Bank of England figures show that the average rate of interest on instant access savings accounts is currently just 0.47%, lower than at any time since the financial crisis. The Bank’s latest Inflation Report endorsed market expectations that interest rates will stay on hold for the foreseeable future. Indeed, whilst possibly overly conservative, markets are pricing in a first rate rise as late as November 2018.

Additionally, investors who ‘wait on the sidelines’ in cash face the challenge of timing when to get back into the market, which history has shown is almost impossible consistently to get right. It is for this reason that investors who drip-feed money into the markets, through regular savings or phased investment, can help cushion themselves from volatility and avoid the worry of investing at the wrong time.

It is also important that investors look past the headline stock market indices and understand the benefit of maintaining a diversified portfolio; one which includes a broad spread of equities, but also other assets such as corporate and sovereign bonds, commercial property and alternative assets. Investors with well-diversified portfolios will not have been immune to the market falls, but the impact will have been reduced.

But there are positive consequences of the ‘panic’ selling of equities in times of trouble. When risk aversion hits a peak, investors move from equities to bonds and other less risky assets. That pushes down the price of equities, enabling investors who are prepared to be patient to pick up high-quality companies at exceptionally low prices.

The chart below, which shows the relationship between the yield on gilts and UK equities, illustrates this point. The long-standing relationship was inverted at the beginning of the bull market that followed the financial crisis as investors shunned equities in favour of ‘safe-haven’ assets. Whilst we may not be at that same stage in the market cycle, the chart suggests that equities present a better solution for attractive yields than so-called ‘safe haven’ assets.

Long-term gilt and equity yields

Source: Financial Express. FTSE All Share index and UK government 10-year gilts. Figures to 8 February 2016. Please be aware that past performance is not indicative of future performance. Returns on equities cannot be guaranteed. Equities do not provide the security of capital characteristic of a deposit with a bank or building society.

Holding the appropriate levels of cash and other less risky assets is an important defensive strategy. It ensures ready access for funds needed in the short term, whilst allowing investors to remain invested in assets that yield more attractive levels of income, providing the scope for improved longer-term returns.

History may not repeat itself, but it is worth highlighting the performance of equity markets in the periods following times when investor nervousness is at its highest and confidence at its lowest. In the vast majority of occasions, subsequent five year periods have been particularly rewarding for those investors who are prepared to ride out the short-term worries.

Five-year returns following market downturns

Source: Financial Express, FTSE 100 Index. Please be aware that past performance is not indicative of future performance.

  • We do not know what will happen to markets in the short term, and forecasters who say they do should be viewed with suspicion.
  • While global economic growth is slowing, progress is steady and we do not believe that we are heading for a global recession.
  • The best fund managers, and investors, are able not just to look through the market noise – but to profit from it.
  • Drip-feeding money into the markets remains a sensible strategy in order to counter volatility and reduce concerns about investing at the ‘wrong time’.
  • A well-diversified investment portfolio provides the right foundation for investors to reduce risk and increase their ability to achieve long-term investment goals.

S.W. Mitchell Capital, Aberdeen Asset Management and Majedie Asset Management are fund managers for St. James’s Place.

The information contained is correct as at the date of the article. The information contained does not constitute investment advice and is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

FTSE International Limited (“FTSE”) © FTSE 2016. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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