by Tom Stevenson, Investment Director at Fidelity
28 March 2016
If you’d nodded off over the Christmas break, Rip Van Winkle-style, and just woken up again you’d be forgiven for thinking that nothing much had happened in the first quarter of 2016. The US and UK stock markets look like they will end up pretty much where they began. The reality, of course, is that it has been a tale of two halves – six weeks fretting that the Federal Reserve might be hiking rates in the face of an impending recession and then six weeks of relative optimism.
What really struck me about the stock market’s double bottom in the first two months of 2016 was how the equity and commodity markets moved in lock-step. You might think that a falling oil price would be good news for stocks but below a certain level, cheap energy stops being a positive for consumers and businesses and starts instead sending worrying signals about the health of the global economy. Once investors decided that the Saudis would not tolerate an oil price in the mid-US$20 range for long, it was no surprise that both the oil price and shares rebounded again.
The third striking feature of the first three months for me – and one that may restrain investors’ enthusiasm – was the changing mood music around dividends. In a low-growth, low-interest-rate world, equities have been a beacon of hope for yield-starved investors. During the quarter, though, a number of significant dividend payers faced up to reality. BHP Billiton acknowledged the cyclicality of its industry and told investors to stop expecting a rising pay-out, come what may. From now on, if profits fall, so too will the dividend.
So is it safe to go outside again? Sentiment is certainly easing. Global growth is positive if uninspiring. Central banks appear to have had a quiet word in Shanghai recently and decided that monetary policy divergence was unhelpful. A cap on the rising US dollar – a kind of Plaza Accord-lite – takes the pressure off emerging markets and eases the pain for US exporters and overseas earners.
I like to keep an eye on Citi’s checklist of bear market red flags. Back in 2000, 17 of its 18 signals were flashing. In 2007, 13 of the 18 were sending out a clear warning that the market was too high. Today, just a handful look worrying – the level of takeover activity, corporate borrowings and a widening gap between the yields on risky company bonds and safe government ones. Two of Citi’s categories of signal – valuation and sentiment – are sounding the all clear for equities.
I’m less relaxed about bonds, where the sweet spot of an acceptable balance between risk and reward, looks increasingly hemmed-in. Paying governments to look after your money as interest rates turn negative is a case of the greater fool theory. Meanwhile, high-yield bonds look vulnerable to a rising corporate default rate. Only the highest-quality companies offer a yield that’s high enough to offset the risk that it won’t be delivered.
The part of the market I remain optimistic about is commercial property, where rising rents are building on an already high-starting income. It’s like starting the sprint 20 metres down the track.
The big question looking forward is whether the twitching in contrarians’ antennae about commodities and emerging markets is well-timed. It feels a bit early to be getting back into metals, where over-supply is still a drag. Oil feels more attractive although the speed with which shale capacity can be turned back on again threatens to cap the price not a great deal higher than it stands today.
There’s no doubt, though, that the mantra of developed markets good, emerging markets bad has run its course. The US has weathered the deflationary storm well but looks pricy. Emerging markets are risky but after a five-year bear market valuations are back to levels not seen since the start of this century.
There are plenty of good companies at great prices and the balance of risk and reward even in out of favour regions like Latin America is starting to look interesting.