I’ve spent the past week in the US, writing this update in New York. This week has been very challenging for anyone holding equities, albeit offset by gains on bonds, so it’s timely to share some views on the US economy and the source of the concerns
Last year we explained that we thought US equities would need to fall 20-30% in order to see PE ratios better reflect the world economy’s mediocre growth rate. Unless earnings increased (they fell in 2015), US equities would need to fall to around 1,600-1,700 points on the S&P 500 Index. That’s still more than 10% below the current market level. While Australian equities had a poorer year than the US last year, we are still not immune to falling US markets in 2016. Even CBA’s share price has fallen 8% in 2016, exactly the same as the S&P500 in the US.
Much of the past week’s falls have been blamed on concerns about the Chinese markets and economy. But it’s much broader than that. The concerns are about China and specifically concerns that China isn’t likely to be strong enough for the world to achieve the growth that equity markets have built in. Valuations, for example price/earnings ratios, are simply too high if one applies realistic growth assumptions. Dividends won’t be growing as fast as equity markets are assuming, and so prices of shares need to fall. For readers of The WIRE, this is not news.
What triggered the correction in the past two weeks is a little bit more interesting.
Trigger #1: China’s ban on large shareholders selling was due to expire Friday 8 January
The ban was imposed in July 2015 when Chinese equities first tumbled. The problem with any such ban is that eventually it must end and if conditions worsen in the meantime, all it does is create large volume selling on the day the ban ends. That was exactly the scenario the world feared on Friday 8 January. The ban was extended indefinitely while new rules are drafted. Citigroup has estimated that when the ban does end, there will be an additional USD15bn per day in selling pressure. Given that Chinese equity markets have fallen despite the ban, this additional selling pressure is a serious problem for world equity markets.
Trigger #2: US GDP growth rate in the 4Q2015 was around 0.6%pa
Markets had been assuming around 2% p.a. growth in Q4, but several indicators now point to a much lower growth rate:
- Retail sales grew at their slowest pace since 2009
- Inflation remains weak
- Wage growth isn’t climbing despite (perceived) high employment
- manufacturing is in a recession
- Exports remain weak due to the high dollar
Consumer spending is particularly worrying. Confidence is up and energy prices are down so spending should be stronger. Retail spending is partly depressed by the accelerating use of online shopping and this won’t change for years yet, but the impact on the older parts of the economy is significant. Walmart announced it would be closing 25% of its major stores this year laying off 16,000 employees, for example.
Trigger #3: Oil
Lower oil prices are taken by markets to be a sign of weak demand for oil, which in turn is an indication of weaker economic conditions. News of rising inventories (the amount of oil or oil products in storage) spooked markets, and rightly so. The only excuse for rising inventories is the unusually warm northern hemisphere winter meaning there is less oil needed for heating. On the other hand, the UN just announced that they have issued the final certification that Iran has complied with its requirements under the nuclear arms deal, meaning that sanctions will be lifted. Iran will commence oil production immediately and in fact can now start selling the oil they have in storage. If this sales and production process is faster than expected, oil could fall even further.
Sentiment in the US remains strong, despite all of this. The real economy, as opposed to Wall Street’s assumptions about the economy, continues to be good but not great. Consumer debt is around 30% lower now than it was in 2008 and banks are carrying 45% more capital buffer, meaning the banking system is far less likely to seize up like in 2008/09.
What needs to happen though is that Wall Street needs to come to terms with the weak growth rate and adjust their forecasts accordingly. This year will be a very challenging year for equity holders. And once again, we expect bond yields to finish the year lower than the market anticipates.
Government bond yields in both Australia and the US fell steeply, meaning prices rose. US yields are now around our forecast levels of 2.0% p.a. (closed at 2.0347% on Friday). Australia’s 10 year bond yield is still higher than we believe represents a realistic outlook for rates in Australia. It closed Friday at 2.69%, which is down 17bps since December but still up on this time last year. This doesn’t accurately reflect the weakening outlook for China and the impact on the Australian economy.
Implications
Take a very cautious approach towards equities and if you see opportunities to sell on rebounds, consider the option of Australian bonds with duration, preferably in investment grade (lower risk) and ideally in infrastructure to avoid any further decline in economic conditions. Look for opportunities to hold duration in US bonds if market yields rise above 2.10% again.