In the midst of heightened anxiety over the possibility of another financial crisis and market turmoil, 2016 marks the 400th anniversary of Shakespeare’s death. While most people don't pick up Shakespeare's plays when they're looking for investment advice, Shakespeare did write frequently about money matters.
“How poor are they that have not patience! What wound did ever heal but by degrees?" – Iago in Othello in Act 2, Scene 3. Or in plain English: patience pays off.
“Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry." – Polonius in Hamlet Act I, Scene 3. In other words, don't spend money you don't have.
“Foul-cankering rust the hidden treasure frets, But gold that's put to use more gold begets." – Venus and Adonis, a poem. Or more simply: Don't put your money under the mattress.
Where the Bard and markets meet
Shakespeare’s plays often turn on the idea of fate. Controlling one’s fate seemed to have become part of the human consciousness by Shakespeare’s time but not yet the competencies to achieve that end. Instead, those who tested fate usually ended up dead. These themes are explored most vividly in The Tragedy of Julius Caesar. Caesar receives all sorts of apparent warning signs, which he ignores, proudly insisting that they point to someone else’s death. Then Caesar is assassinated.
Given the rough start to the year, you may wonder if we made the same mistake as Caesar by ignoring the warning signs. After all, our expectation for a better 2016 (compared to 2015) did not get off to a good start.
What was the trigger for such a panic in January? China, oil and Fed worries were nothing new. The same worries led us to take out portfolio hedges and reduce growth exposure from the second half of 2015 when market complacency was high. While these tail hedging strategies paid off, they were not enough to offset the negative contribution from the exposures to commodities and Asian shares.
As 2015 drew to a close, many of our sentiment and valuation indicators had made a significant positive adjustment (mostly during the August-October correction), macro indicators were showing signs of steady improvement and financial conditions in China were looking up. Then a few people got back to work in early January and listened to interviews by some hedge fund gurus on how China is about to implode and that central banks are out of ammunition. Panic buttons were hit despite the fact these gurus have been making the same predictions ever since the GFC. With markets down sharply, the next group of sellers showed up and decided to sell based on the idea that 'maybe the market is telling us something’.
Reasons not to join the panic
For now, major equity indices have found support at key support areas, as markets now focuses on:
- Little or no signs of credit crunch even as global banks came under fire.
- Easing financial conditions in China, and after a year of monetary easing, real yields are falling and loan growth is picking up steam.
- Significant improvement in valuation measures. Of course, valuations are not great timing indicators and just because valuations are cheap doesn’t mean markets can’t fall further. However, when valuation signals move to historical extremes, it pays to take notice.
History shows time and time again that strong positive returns can be achieved by investing in the share market when the economic news is negative, and bad news is well covered and reflected in valuation measures. However, investors as a group fail to exploit valuation anomalies. Why? Because there is a price to pay and that’s accepting short-term volatility.
While downside selling pressure has shown signs of easing, evidence of buying pressure will need to emerge. Improved earnings prospects against much pessimistic expectations and further policy support from Europe, China, Japan and US (through delayed further rate hikes) should lead to reduced short-term volatility and a re-rating of equities. The most significant risk to market stability, however, continues to be the US dollar.
What if China implodes?
For Chinese H shares, valuations (extremely cheap), cycle (leading indicators of growth are turning up), monetary policy (significant improvement in monetary conditions), technicals (waning downside participation across individual stocks) and sentiment indicators (extreme pessimism) are all green. Rarely do we find an asset class that gets a tick across so many drivers.
Of course, none of this matters if the predictions of some US hedge fund gurus are right and Chinese banks collapse. Their calls on financial Armageddon in China have gained widespread coverage (so much that we received several emails from some worried clients).
In our view, as with all things in China, the spectre of a financial crisis is an intensely political concern. Should a financial crisis occur in China, it will be because all options to prevent such a profound dislocation have been tried and failed. Indeed, China is one of the very few countries in the world with the ability to boost fiscal support, and that’s what we have seen in recent months.
In summary, despite the intense market weakness since the start of the year, increasing calls of an imminent global recession and financial meltdown, our focus was and is to remain objective. We continue to expect market turbulence to settle down soon. Further breakdown in emerging market currencies, another bout of underperformance by cyclically-sensitive sectors and falling inflation expectations (pushing real yields higher) will be examples of such dynamics that will warrant a shift in allocation towards a more defensive stance.
Nader Naeimi is Head of Dynamic Markets at AMP Capital. This article is a general view and does not address the specific circumstances of any investor.