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The decoupling of the US business cycle from the rest of the world has led to a sharp rise in the dollar, which was becoming too constraining on China. The exchange rate regime shift announced by Beijing in August served as a catalyst for the broad-based decline of equity markets; a decline that may prove to be a reference.
In fact, this decline is punctuating the equity market cycle. But we think it is only temporary. Once reassured on the path of world growth, the markets will rally and the clouds obscuring the 2016 horizon will lift. Not all doubts have been erased so far and there could be pitfalls along the way.
The length of the market cycle: an indicator of choice at this stage of the cycle
A distinction should be drawn between an equity market cycle and an economic cycle. An economic cycle can have several acceleration and deceleration phases until a recession comes along to end them. As equity markets anticipate and accentuate economic changes, a single economic cycle can contain several equity market cycles (See our Discussion Paper: “The short investment cycle: Our roadmap”). It starts with a major low point, below the 200-day moving average, and ends with the last major peak before a significant break in the 200-day moving average. It is a tremendous addition to the analysis of central banks’ monetary policies to help us find our way around the investment cycle.
The world equity markets have been rising since March 2009, i.e. for 78 months (See graph 1). Our historical observations show that over the past 120 years, equity market cycles have lasted an average of 46 months (from bottom to bottom). This observation is all the more striking when you look at the average of two consecutive equity market cycles. The previous cycle (2006-2009) lasted only 32 months due to the sheer scale of the market slide, which was particularly dramatic after the collapse of Lehman Brothers. If this observation is any indication, the chances are high that a market low point will be reached before the end of the year.Otherwise, the average of the two consecutive cycles (ongoing for 55 months now) may end up exceeding the longest duration recorded in history.
The equity market correction would therefore bear a closer resemblance to that end of the economic cycle, which is not expected to occur in 2016.
This baseline scenario assumes that:
Fears of a hard landing for China and a deflationary spiral in the emerging markets: investor capitulation selling is not over
The declining profitability of emerging market corporations began in the aftermath of the 2008 crisis and is by no means a new phenomenon. The rebound that followed the stimulus provided by China (China pumped about ten percent of its GDP into the economy in the form of a stimulus plan) was not enough to drive corporate profitability to record highs (See graph 2). ROE (return on equity) resumed its downtrend shortly thereafter. Emerging currencies followed the same pattern, with an accelerated decline in the second half of 2014 and again this summer. Note that so far the downtrend of emerging currencies has been restricted to the weakest economies, especially the commodity producers.
However, since the summer, and even before the devaluation of the renminbi, Asian currencies have been drifting lower. The emerging market downturn has now become generalised (See graph 3).
There is a simple rule for investing in emerging equity markets: invest when the currency trend is back on the rise. Thus far, observing this simple dictum has kept us from any temptation to overweight this region since 2011. With outward flows from emerging markets at full throttle and ROE on the way to sinking to its all-time lows of 2003 and 2009, one might very well wonder whether the emerging markets are now in the midst of an investor capitulation phase.
For now, the trend is to the downside. Investor capitulation selling suggests a swing phase to allow the bears and the bulls to swap roles. So far, we have been watching a falling knife situation. The trend in the commodities trade – a reflection of Chinese and world economic growth – is not showing any signs of recovery. By the same token, given the bearish reversal of the commodities bull market at the turn of the last decade, it is not unjustified to think that downturns pack more punch than upturns; this also goes hand-in-hand with the downward revision in global growth potential. Finally, rising short- and long-term market rates in several emerging countries continue to undermine the financial health of those economies and power the vicious downward spiral.
Although prices have begun to reach more attractive levels (Price-to-Book Value Ratio at -1 standard deviation relative to an historical range going back to 1996), they are not low enough without any catalyst. The same goes for capital flows (outflows stand at -1 standard deviation). It is time for China's policy of small steps (on the reserve requirement ratio, interest rates, stimulus package and the devaluation of the renminbi) to start producing the desired results or, failing this, an announcement of a massive financial stimulus package to restore the necessary degree of confidence.
Caution is still the watchword for emerging markets. It is too soon to start repositioning. Graph 4 highlights the similarity to the situation a decade ago. In 1997, the Asian financial crisis sent emerging markets plunging to far lower levels, both in absolute terms (a 60% decline compared to 30% today) and in relative terms when compared to the developed markets. Although the Chinese slowdown was seen to be under control , which has first slowed down the underperformance of this asset class, the summer's procrastination laid the groundwork for a major shift. This graph demonstrates that the risk of a stall cannot be ruled out.
As a result, we still prefer developed countries to emerging countries due to their risk-return ratio. It should be reiterated that during the 1997-1998 Asian financial crisis, the mature markets held up fairly well until LTCM, a hedge fund, collapsed in August 1998, triggering energetic intervention by the Fed. During the most recent FOMC meeting, the Fed took readings on international developments into account, essentially ending up on the same side as risky assets. In the event of a shock, we can well imagine that the Fed could go further and might even let down its guard.
The US consumer: the consumer of last resort
Our economists predict that world economic growth will hold steady at around 3% in 2015 and 2016, primarily due to domestic growth in the mature economies, led by US consumption (see graph 5). It remains a fact that consumption accounts for 70% of US GDP and that if the Fed plans to raise its rates, it is because this particular component is strong.
The United States has never had a recession in any year immediately following a 50% plunge in the price of oil, as is currently the case. Plunges have occasionally produced the opposite effect, i.e. an oil counter-shock (1986 and 1998). Moreover, the S&P 500 has always moved higher in the 12 months preceding a US presidential election (See graph 6), except in 2008 (collapse of Lehman Brothers), 1988 (crash of 1987), 1940 (WWII) and 1932 (the Great Depression). It is true that the pre-election period encourages government largesse. Barring an extreme event, all this bodes well.
Lastly, rising high-yield spreads and the peak in corporate margins (fourth quarter 2014) underscore the maturity of the cycle. It is important to point out that historically recessions occur, on average, only six quarters after peak corporate profits, but with the maximum being the 15 quarters that occurred in the 1960s and 1990s. From this perspective, there is no doubt that the end of the economic cycle is drawing near, but it is not going to happen overnight.
Beyond the issue of corporate margins, the stabilisation of US corporate profits is more disturbing. In fact, when the post-crisis markets were enjoying a strong rebound post-LTCM/Asian/ Russian financial crisis (between 1998 and 2000),or when the subprime bubble was forming (2006-2008), corporate profits were clearly trending upward, which does not appear to be happening this time (due to wage increases and a strong dollar).
The less volatile US equity market is more defensive than other major equity markets during this phase of financial stress. However, it does not have all the ingredients to outperform when global markets begin rising again.
Conclusion: we are constructive... but not in a hurry
In terms of timing, doubts about China and commodities do not give us any particular reason to put risk back into the portfolios right now. We prefer to wait a bit longer. Remember that we have been in economic winter since 2000 (See our Discussion Paper: “Long cycles and the asset markets”) and that it is better to err on the side of caution at this time. However, equity markets will eventually break-out and achieve higher highs in 2016.
In geographical terms, we can expect China to offer reassurances and the United States to maintain resilient growth, but the main beneficiary may ultimately be the eurozone. The eurozone has more potential for acceleration in terms of profit growth. After a double-dip recession, it is taking advantage of the weak euro, a central bank that stands ready to do more, the recovery in lending and the decline in oil prices. According to our projections, falling emerging currencies could still cut the outlook for one-year profit growth in half. However, after the analysts in the financial community will have revised their figures, there will be 5% earnings growth left in their forecasts. And if emerging currencies manage to stop their downward spiral, the trend may again start moving in the direction of upward revisions.
As to Japan, the situation is much like that of the eurozone, but the profit cycle has started before. While the yen is historically the currency that is the most resilient to crises (1998 and 2008, for example), not having to hedge foreign exchange risk makes it easier to weather the storm (at least for anyone investing in dollars). Another approach is to neutralise this market. For that matter, our allocation models are telling us that, in dollars, there is very little difference between the three major regions: the United States, the eurozone and Japan.
With regard to themes, “China risk” is finally causing exaggerations in the outperformance of growth stocks over value stocks, as we suggested in our Cross Asset Investment Strategy of January 2015: “Growth stocks: risk or opportunity?” Cycles in which growth stocks outperform have frequently (if not always) ended with exaggerations in favour of these stocks (see graph 7). With interest rates extremely low, profit growth a rare occurrence and few if
any investment alternatives, this theme remains relevant, especially for those stocks that are sensitive to the domestic consumption of mature economies. It is even a theme of choice to focus the excesses that are often seen in this kind of market phase, where a new equity market cycle ties in with the end of the economic cycle (as in 1998-2003 or 2006-2009).
Nonetheless, looking closely to the graph, we highlight that the exaggerated performance of growth stocks relative to value stocks is often cut abruptly short before picking up again for a final jump. This time, we can easily see a (potentially technical) rally of stocks with exposure to China/emerging countries/ commodities taking place at any time, which, paradoxically, represents now a portfolio risk. If the equity markets are due to come out on top amidst all this turmoil, the road ahead promises a rocky one.
The equity market correction bears a closer resemblance to that of 2011 than that of 2000 or 2008
While the risk associated with the elections in Europe is increasing, we are more concerned with the overvaluation of the leading market (the United States). To simplify, the equity markets maintain hope of gaining 5-10%, but that investors seeking to profit from it are running the pending risk of facing a shock of 20%.