Markets became agitated as weak emerging economies saw their currencies slide, liquidity concerns in China became more pronounced and economic data from the US disappointed. The reality is that the US economy is consolidating after strong gains in the third quarter; vulnerable emerging economies running current account deficits are struggling to attract capital to keep their currencies stable; and China is struggling to maintain order as it tackles problems in its financial sector.
However, these issues are not the end of the world. We believe investors should look for buying opportunities rather than sell now. Prior to recent concerns, emergingmarket equities performed very poorly over 2013, discounting much of the bad news. Emerging-market debt spreads (yield premium above safe-haven government bonds to reflect higher risk) are about two-thirds of their peaks seen in the mini-crisis last summer. In the developed world, the US economy is consolidating but the European and Japanese economies continue to deliver good news.
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China’s stresses
Weaker-than-expected data from China and the failure of a financial product in the Chinese financial sector led the troubles from emerging markets last week. Maybe perversely, we continue to see the problems in China as a sign of progress, not pending disaster. The recent flow of poor news largely reflects the efforts of authorities to reform the financial sector. The near-term challenge is for the authorities to manage the potential losses that banks and individuals will have to absorb and maintain sufficient liquidity in the system to keep market interest rates at a reasonable level.
In our view, it would be wrong to be too negative on China. Last week’s data showed that Chinese industrial production increased by 9.7% and fixed investment by 19.6% year-on-year in December, while retail sales increased 9.7% in November. Such data shows that the Chinese economy is growing more vibrantly than most other major economies. Meanwhile, the equity market languishes on a single-digit price/earnings (PE) multiple. To us, the bad news is well discounted, albeit we accept that you may have to be patient and wait for your returns.
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Emerging currencies under pressure
Turkey, Argentina and Ukraine led the list of emerging economies hitting the buffers last week. In Turkey the lira sank to an all-time low while Argentina saw the peso fall 15% to a 12-year low. Ukraine street protests continue amid ongoing political fallout.
Turkey is perhaps the most worrying as it could lead to greater contagion across emerging markets. Turkey was always vulnerable to the trimming of bond purchases (quantitative easing or QE) by the Federal Reserve (Fed) given that it continues to need significant capital inflows to prop up its currency. The lira has now fallen 9% this month.
The central bank attempted to support the currency by spending $1.7bn of reserves on intervention in the foreign exchange markets, but to date has achieved very little. Turkey could very soon run out of reserves, prompting the central bank to have to increase interest rates. If there was significant contagion across vulnerable currencies, the South African rand, Indian rupee, Indonesian rupiah and Malaysian ringgit could all come under some downward pressure.
Thailand: key date ahead
National elections due in Thailand on 2 February may prove to be another catalyst for turmoil. Although the equity market has shown some resilience in recent trading sessions we are loathe to chase it as there remain considerable downside risks. It is still not certain that the elections will take place, with either a postponement or direct military intervention possible.
The negative impact of the troubles on economic growth and corporate profits are just starting to work their way through the system. Most economists seem to be shaving a full percentage point off gross domestic product (GDP) growth forecasts for 2014, down to around 2.7%. We would consider buying the index at closer to 1,200 but not the current 1,300 level.
Fed to continue trimming QE
All eyes will be on the Federal Open Market Committee (FOMC) meeting this week. The market expects monthly QE to be trimmed by a further $10bn to $65bn a month. Softer economic data last week has some thinking that the Fed may scale back QE less than it did at its previous meeting, although reassessment is more likely once Janet Yellen takes over the Chair of the committee at the subsequent meeting in February.
Underweight US equities but scope for capital gain
Our underweighting of the US equity market has so far been vindicated by a lacklustre performance since the start of the year. While we would still argue that we expect US equities to underperform, they should still deliver some absolute return this year, of around 10% from current levels.
We note that despite what has been still-robust economic data, US fund managers have taken very defensive market positions. Short interest (predicting the market will fall) is at its highest level since 2008 and active managers have taken very defensive positions in their portfolios by either holding a greater proportion in cash or holding very defensive stocks, such as pharmaceuticals, that typically perform well in a falling market.
A spark of better news may force funds to seek to cover their short positions by buying equities, and managers who have been very defensive may commit cash to the market and/or switch from defensive sectors into cyclicals. It has not been all bad news for cyclical stocks with the materials and industrial sectors seeing around 40% of their constituent companies’ share prices hitting one-year highs.
Eurozone continues to perform
It’s not all bad news. The eurozone economy again reported some good economic data last week. Confidence indicators for the industrial and service sectors, and from consumers, came in well ahead of expectations. In Germany, industrial confidence rose sharply to the highest level since mid-2011. We are pleased with the consistency of the improvement seen in the eurozone over the past three months. The growing sense amongst investors that the recovery is sustainable should support further relative gains from the equity market.
Quality yield stocks plus technology
We favour balancing equity market portfolios of yielding stocks with non-dividend-paying holdings such as technology companies. It is worth noting the better share price performance over recent weeks of companies that have low dividend yields. We believe that investors are becoming much more discerning when investing for yield. As we have argued previously, investing in high-dividendyielding stocks just because they have high yields is a strategy of the past. Investors still want yield but they also want to ensure that the yield is at the very least secure, if not growing strongly in the future.
In the US market, if you wanted to maintain some capital growth while at the same time maintaining income the strategy so far this year has been to combine an income strategy with exposure to the technology sector. Carla Fried of ycharts.com pointed out in a recent article entitled Noincome stocks crushing the market that non-dividend-paying stocks outperformed the S&P500 index in the year to November 2013 by close to seven percentage points. Many of those non-dividend-payers were technology companies.
Gold a portfolio stabliser
The sell-off in emerging markets provided a stimulus for the gold price to reach a two-month high. A number of technical analysts are targeting a break above $1,280 for a further sharp rise in the price. Gold’s rise in an environment of concerns over emerging markets is a good illustration of why we believe investors in Asia should target holding at least a 2-5% weighting of gold in their portfolios. Indeed, for any investors with a significant exposure to emerging-market assets, gold can provide a good stabiliser when emerging economies suffer wobbles. Recent events have shown that problems in individual countries can bring solid new buying. When the Turkish lira came under attack last year Turkish investors increased their holdings of gold considerably.
Gary Dugan, chief investment officer for Asia & Middle East, Coutts
