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We have just reduced our equity holdings slightly

Chief analyst Bo Bejstrup Christensen is generally positive on the global economy, but expects risk to increase going forward.

After more than ten years working with global investment strategy, I have witnessed my share of spectacular financial market events. Among the biggest I would count the financial crisis in 2008, Greece’s near meltdown and, most recently, the collapse in oil prices – to mention just a few. Nevertheless, I am still constantly amazed by the speed at which market sentiment can shift – and that is the case again this year. When we decided to increase our equity holdings in January, the market’s jitters were palpable. Fears of China collapsing, a US recession and a European bank crisis stole the headlines and sent most risk assets into freefall.

Now, just 2-3 months later, these concerns have, if not quite disappeared, certainly faded. Global equities have recovered by around 10% from their lows, oil and commodity prices have rebounded strongly and corporate bond yields have fallen significantly. Is this a green light to further major price increases? We say no – more like an amber light, a cautionary signal, which is why we have decided to sell some equities in our balanced portfolios.

First the easy part – the pessimists were wrong
A quick recap. China’s government has stimulated the economy and stabilised its currency. As I write, the Chinese yuan (CNY) is marginally stronger against the US dollar (USD) than it was at the start of the year. Moreover, China’s all-important housing market strengthened in Q1, with home sales sharply up and house prices rising significantly. This appears to have stabilised construction and thus certain commodity prices.

The US, meanwhile, managed to avoid its much-feared recession – the long-suffering manufacturing sector even surprised positively via significantly higher business confidence, while the labour market has continued its indefatigable progress, with strong job creation and signs of increasing wage growth. Despite this, the US central bank, the Fed, clearly signalled that uncertainty remains high and therefore monetary policy would be tightened very cautiously – an undoubtedly positive stance for US equities and emerging markets, which traditionally suffer when dollar yields rise.

The European economy continues to grow despite major political challenges, and the European Central Bank, the ECB, has again eased monetary policy very significantly.

Finally, oil prices have risen on the back of a seemingly significant slowdown in US oil production and hopes that OPEC will stabilise output – boosting US corporate bonds and commodity-heavy emerging markets. In short, the prophets of doom were (once again) proved wrong.

Looking ahead – the good news first
The good news is that we remain essentially optimistic on the global economy.

We expect US growth to pick up further as the negative shock of the stronger greenback fades. We also expect the housing market to continue its recovery and the bank system to remain stable and supportive of growth. We currently estimate US growth to be around 1.5% annually and forecast it to rise to at least 2.5% over the year.

In China, we expect more of the same. Cutting the down payment required by first-time home buyers has triggered a minor boom. And while housing market sales activity cannot continue to rise at the current rate, there is further stimulus in the system, for example from record-high credit growth, which in our view is a badly disguised fiscal easing – and fully in line with China’s usual methods of fine-tuning growth.

While the political challenges appear to be piling up in Europe, the generally healthier bank system and new initiatives from the ECB, such as additional liquidity facilities, should ensure that bank lending increases and thus promotes growth. We estimate that growth will hover around current levels of 1.5-2.0% in the coming quarters, resulting in further job creation and falling unemployment. Unemployment will, however, remain high, while inflationary pressures look set to remain very low, so the ECB will likely continue its extraordinarily accommodative monetary policy.

Essentially then the global economic recovery is still ongoing and should benefit both companies and consumers. We therefore continue to see potential in global equities.

We have nevertheless sold some equities
Nevertheless, we have decided to sell off some of our equity holdings. We are, roughly speaking, selling an amount equivalent to what we bought in the dark days of January. Our reasoning was fivefold:

First, equity prices are simply no longer quite so attractive. This is of course a direct result of prices rising.

Second, we remain sceptical about China’s growth prospects, both long term and also later this year. The current strength of China’s housing market is primarily due to government stimulus – be that via easier access to home loans or rising infrastructure investment. But a stimulus is by nature temporary – cutting the down payment requirement simply brings forward tomorrow’s demand to today. The advantage is that China’s large stock of unsold homes will shrink and thus benefit construction going forward. The disadvantage is of course that tomorrow’s demand will be reduced. Car sales are another excellent example – sales were falling modestly up to late summer last year. Then the government introduced a subsidy scheme for small (more environmentally friendly) cars and sales virtually exploded, rising 30% by December, before falling again here in 2016. We do not expect to see comparable swings in home sales, but they will begin to decline again later this year, in our opinion. Given the still large stock of unsold homes, especially in the smaller towns and cities, and the significant fall in the young and most mobile sections of the population in the slightly longer term, we estimate that construction activity will at best stagnate – and at worst decline further. That will put a damper on the nascent optimism surrounding certain commodities.

Third, we view the fixed income market as unduly reluctant to accept future rate hikes from the US central bank. The market is barely pricing in one rate hike this year, while we forecast the strength of the labour market and especially accelerating wage growth will prompt the Fed to hike at least twice more this year. That will put upward pressure on both US yields and the dollar and thus turn these tailwinds of recent months into headwinds. We assess this to be slightly negative for risk assets in general and for the emerging markets in particular.
 
Fourth, we would still question the direction of oil prices. While increasing evidence of a production slowdown is a stabilising factor, further price rises would essentially be self-defeating in that a price of, say, USD 60 a barrel would quickly make many US producers profitable again and probably lift production, which would in turn put downward pressure on prices.
 
Finally, political risk will move centre stage as the UK’s ‘Brexit’ referendum and the US presidential election get closer. These events will be major headline grabbers and if they unfold against stagnating-to-falling Chinese growth and a reassessment of US monetary policy, volatility will surge.
 
In a nutshell then, potential return is down and going forward risk is up, so risk/return has deteriorated. We have therefore sold off a little of our equity holdings – mainly in Europe – to protect our customers and portfolios against that difficult-to-quantify political risk. Nevertheless, we have preserved a slight overweight in equities, reflecting our generally optimistic view on the global economy. Going forward to the summer, we will be keeping a particularly close eye on China and the US.

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