The severity of the current market correction (-16% on the Euro Stoxx since the beginning of the year(1)) took many investors by surprise, including us. In this volatile context, our response is to try to understand the markets’ fears and gauge whether or not they are founded. Nothing would be more damaging to long-term portfolio performance than selling after a steep fall and missing out on a potential recovery should the fears prove unfounded.
What specifically are the markets so afraid of? Fears seem to be accumulating rapidly and fuelling investors pessimism. First it was China, then oil and now the US economy and the stability of the financial system. Disoriented investors have taken the correlation between equity markets and oil prices to a new level. Markets are reacting as if we were at the dawn of a new 2008. However, a deeper analysis of the situation indicates that what we are experiencing is more of a panic in the markets than a real deterioration in Fundamentals.
1.Will Chinese growth collapse in 2016?
The market’s mood began to darken last summer when the Chinese central bank (PBoC) changed the way it manages the yuan-dollar parity in a bid for the yuan to better reflect market forces. The move was misinterpreted as the start of a competitive devaluation, paving the way for a new currency war. We believe this decision chiefly reflects China’s desire to internationalise and stabilise the yuan, with a view to it becoming one of the world monetary system’s major
Currencies (see Chart of the Week “Chinese currency sends shockwaves through markets”). Many estimates show a relatively low exchange rate impact on Chinese growth.
Is the Chinese economy on the verge of a new recession? We doubt it. Consumption is gradually taking over from other sources of demand, which naturally implies a slowdown in the country’s growth. What are the main imbalances affecting the Chinese economy? The answer is undoubtedly previous over-investment in real estate and in certain industrial
sectors, such as aluminium and steel, which are now suffering from surplus production capacity. Furthermore, excessive reliance on debt to finance these investments has also led to fragilities in the financial sector.
In real estate, adjustments are underway, and there are encouraging signs, such as the rebound in Tier 1 city prices. As for production overcapacity, on January 22nd the government announced that reducing it would be a priority in 2016. Concerning the fragilities in the financial sector, Chinese banks have the capacity to absorb non-performing loans (RoE of about 20%).
The Chinese government’s objective is to guide the ongoing slowdown. To that end, it has been easing monetary policy in the past year and implementing targeted measures to boost certain sectors of the economy. For example, in September car taxes were lowered, leading to a sharp increase in sales.
Looser monetary policy has been proving its worth for 3 years. Chinese growth should therefore pursue its gradual and, we believe, managed slowdown.
2.Is the fall in oil prices bad news for the global economy?
IMF simulations dating from early 2015 showed significant growth acceleration due to the beneficial impact of lower oil prices, which amounted to a transfer of income from those with a low marginal propensity to consume (oil-exporting countries) towards those with a higher marginal propensity to consume (US and European households). Compared to previous cycles, investments in oil production have been cut in a more abrupt manner, which has concentrated the negative impacts into a very short time period. If recent changes in investment in the sector are anything to go by, it is likely that we are nearing the end of the correction. Furthermore, US households have yet to transform all of their increased purchasing power into consumer spending. The effects of lower oil prices should therefore now be felt mainly in a positive way.
A recent concern is that the price falls of the last six months are a sign of weak demand, itself due to economic slowdown. We believe this fear to be completely unfounded. Demand, far from slowing down, has been constantly accelerating for 2 years. Today, it is growing at its fastest pace since 2010. If prices have slumped again, having stabilised during the summer, it is the result of a surge in production (see Chart of the Week “Oil prices dip below USD 40 a barrel”). On one hand, US shale oil production is resisting better than expected to the fall in prices and, on the other, Saudi Arabia, for strategic reasons and to maintain its market share, has shunned its stabilising role and continued producing at high levels.
For us, the drop in oil prices is in no way a sign of a slowdown. It is quite the opposite, marking the very beginning of a future re-acceleration of the global economy, driven by an upturn in consumer spending.
3.Are we on the verge of a US recession?
Against a backdrop of disoriented investors, deteriorating US ISM manufacturing and non-manufacturing indices, and disappointing capital goods orders, many are predicting that the world’s largest economy is on the verge of recession, and that there will be a spillover to the rest of the planet. For us, the chances of this scenario becoming a reality are very low. Two key factors explain the current weakness in the US economy: inventory cycles and the downturn in shale oil related investment (see Chart of the Week)
“Mining industry investment: significant adjustments in the US”). Aside from these two factors, the US economy is healthy.
Annualised inventory levels are likely to come out at close to $50bn for the fourth quarter in the next GDP estimates, as compared to $110bn in the second quarter. This adjustment has indeed weighed heavily on the manufacturing sector in the second half of 2015, but the impact is waning, and inventory levels of $50bn are perfectly normal for the United States during periods of growth.
The slide in investment by mining industries has already brought it down to historical lows, on a par with 1987, 1999 and 2009. Currently, mining activities only account for 0.4% of GDP and the oil and gas sector account for just 0.2% of jobs. The sector is in no more of a position to lead the US economy into recession than it was in 1986-87. It is likely that the influence of these two factors will diminish in the months ahead and that growth will gather pace in the course of the year.
The rest of the US economy is doing well, as the employment figures show: the number of job openings rose sharply in December. In the past, these numbers have tended to deteriorate ahead of recessions. The very recent increase in weekly unemployment figures is the only cloud on the jobs horizon. This is likely to be a temporary increase due to the inherently volatile nature of weekly jobs data, but is worth monitoring nonetheless.
There remains the question of credit, with some promising an impact on a par with the 2008 crisis, caused not by subprime loans this time around but by the oil sector. However, banks’ exposure, in terms of both amount and nature, is very different. Loans to the energy sector account for 2% of outstanding bank loans, whereas home loans accounted for 40%. The problem is therefore essentially linked to the bond market. Via securitisations, home loans were converted into supposedly safe assets. In the case in hand, bonds issued by oil exploration companies have not been converted. The fact that they are present in high-yield indices clearly indicates their true nature to the market. In terms of prospects, credit conditions have undeniably tightened for private companies, but not excessively, and the data available does not allow for isolating figures specific to the energy sector. In contrast, conditions are still flexible for good quality mortgages. It is therefore unlikely that the US economy is on the brink of a new credit crunch.
Overall, we believe that far from being on the verge of recession, US growth can be expected to pick up again in coming months.
4.Are European banks in for a new 2008?
The European banking sector has been hit particularly hard on the stock market lately, significantly underperforming the major indices during the recent correction.
The fears related to the oil shock have led to a sharp widening of spreads in the high-yield bonds segment, reviving fears of huge losses for the European banking system. Meanwhile, long-term rates have fallen in Europe and the US, reducing the prospect of net interest income.
As a result, European banks’ Credit Default Swaps(2) (CDS) have suffered badly, leaving doubts over their ability to roll over wholesale funding smoothly.
At this stage, however, the doubts are largely unfounded given that in the meantime, the European banking system has changed only very slightly. We certainly don’t see it riskier than it was in 2015. It’s true that the oil crisis could reduce banks’ short-term profitability, but they will benefit in the medium term, as lower energy costs prove to be good macroeconomic news. According to our estimates, the European banking sector is exposed to losses of €28bn in a worst-case scenario (assuming a 50% loss rate on the riskiest segments and a zero recovery rate). If such a loss occurred in 2016, it would be enough to wipe out 25% of the sector’s profit-generating capacity. However, the impact on core capital would be less than 3%.
Although not insignificant, these figures are a far cry from the losses encountered in 2008 during the subprime crisis and, in our view, do not justify hitting the panic button.
Conclusion
These fears seem to stem more from the actual market downturn than the reality of fundamental data. A case of share prices driving investor sentiment? Faced with sharply declining markets, it is perfectly natural to look for a rational explanation and find the dark scenarios. However, markets are not always rational, and we believe that they are perhaps less so today than they have been in the past, due to falling numbers of long-term investors capable of adopting a contrarian stance in market downturns, and the rise of momentum investing and stop-loss systems. The mass selling they provoke during bear markets serves to exacerbate market shifts.
Despite this turbulent start to the year on the markets, we are sticking to our 2016 economic scenario which is similar to that of 2015: global growth at respectable levels, driven mainly by developed economies.
We remain exposed to risky assets, in particular Eurozone equities, as once the dust settles, we believe that the Federal Reserve will pursue monetary policy normalisation, which will weigh on bonds.
(1) As of February 2016 The opinion expressed above is February 2016 and is liable to change
(2) Credit Default Swap = cost of insurance against a default risk
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