There’s a lot of uncertainty in the markets, maybe even the most since the Great Financial Crisis of 2008/2009. The collapse in commodity prices, lackluster global economic growth and a cooling of the Chinese economy, raise a lot of concerns. Still, US unemployment is at very low levels, close to 5% and central banks across the globe have very accommodative monetary policies. Despite a first rate hike by the US Federal Reserve, even more easing is to be expected, for instance by the European Central Bank. Stock markets stand at a junction and it is important for investors to assess what the future may bring to protect their portfolios.
Momentum seems to change
The strong bull run that started in March 2009 can largely be attributed to the power of TINA, There Is No Alternative for stocks. Due to monetary policies that pushed interest rates lower, investors searched for yield and stocks were the best option. Shares of companies are the most attractive asset class in a low-interest environment with abundant liquidity. On the back of low interest, the economy recovered from the GFC. Revenues and in particular profits rose substantially during these years. Earnings per share increased even more, thanks to extensive stock buyback-programs that were, and still are, often financed by borrowing against low interest rates.
The search for yield also pushed market participants to the high-yield bond market, for instance debt issued by energy producers. Due to the shale revolution, driven by high energy prices, demand for this type of debt was high. But as we all know, oil prices have collapsed and a lot of HY debt is now under pressure. According to Deutsche Bank, defaults in the sector have risen to 15% and are expected to go even higher. The investment bank reminds us that during 2002/03, the telecom sector saw a default rate of 35%. Why this comparison? Well, both sectors expanded substantially on the back of (cheap) debt and this abruptly changed.
Will defaults rise further?
Although the energy sector only accounts for 16% of the overall HY debt market, the problem is that interest spreads increased for the HY market as a whole. The problems in the energy sector caused default rates to increase to 3.1%. In itself, this isn’t really an issue for the whole market. However, markets are discounting a default rate of 5% and the analysts of DB point out that once default rates indeed go above 4%, they often continue to go higher, as high as 10%.
Macroeconomic risks elevated, recession fear rises
The collapse in commodity prices hurts oil exporting countries. But also emerging markets are slowing. In particular, the lower economic growth in China (which is still 6.5-7%) triggers concerns. The slowdown in the Asian powerhouse doesn’t help its neighboring countries. A lot of international companies feel the pain as well. Take for instance German companies, such as carmakers, that export a lot to China. Also US-based Caterpillar is a good example. On the other hand, middle class consumption is still relatively strong and the Chinese market continues to be a growth motor for some companies, for instance for Nike.
As noted, US unemployment is at very low levels and wages seem to pick up as well. But industrial production has fallen in the past period and this proves to be a very reliable indicator for future recessions. Although the figures for January were better than expected (0.9% vs 0.4%), the numbers for the previous month were revised downwards to -0.7%. In the past, subsequent negative numbers were always followed by a recession. So this is certainly an indicator to watch for. Another interesting indicator comes from Harry Dent in an article on Investorplace.com. Dent notes that the Restaurant Performance recently turned negative, just like in 2007. We all know what happened next…
Is macro an issue for markets this time?
Now as most investors know, a weaker macroeconomic environment doesn’t necessarily mean hardship for stocks. We’ve seen moderate economic growth in some periods during the past few years and that didn’t stop stock markets from running higher and higher. Nevertheless, a full blown recession, accompanied by a default cycle, could substantially hurt earnings estimates for companies. As DB analysts note, during the past two default cycles, EPS consensus dropped 50% for the whole market, with even 80% for the tech sector, consumer durables and the automotive sector.
Looks scary, in particular for the tech sector and consumer sector where valuations are pretty high. These valuations are for a large part boosted by the search for yield. Nevertheless, the car sector looks quite cheap with price/earnings-ratios of close to 6 for Ford and General Motors. Both car makers also offer decent dividend yields of 4-5%. That means headwinds for the sector don’t necessarily mean significant ‘repricing’, i.e. falling share prices to reflect healthy valuations.
Bulls versus bears and the elephant
There’s an elephant in the room however. As we noted, a large number of commodity exporting countries see a significant drop in revenues. For instance, oil exporting country Norway suffers from the lower oil price. To make this scary for the stock market: the country saves its additional revenues in a sovereign wealth fund, SWF, which is for 60% invested in stocks. Previously we reported that Norway considers to use the SWF to meet its budget. Or in other words, Norway will sell some of its equity assets. And since the SWF has assets worth $816 billion, this are significant flows. Some market strategists are suspecting that a number of countries with a SWF are liquidating some positions already. Reuters reported that up to $700 billion of European shares could be ‘in the firing line’. These SWFs also hold US shares, actually shares from companies all over the world so this is a problem for stock markets across the globe.
To make liquidity issues worse, investors are pulling their money from equity funds. Bank of Merrill Lynch reported that in the week of February 17, equity funds saw outflows of $12.2 billion. In the past seven weeks, $53 billion was pulled out of equities. Investors are switching to risk-off scenarios due to weaker macro conditions, and that means they sell shares.
Central banks to the rescue?
With commodity prices at current low levels, there’s a lot needed before SWFs will return to the buy side. A low oil price will also increase the risk for a full-blown default cycle and a looming recession. So a lot depends on the oil price. However, not all hope is lost. Central banks stand ‘ready to act’, to quote ECB President Mario Draghi. As the Bank of Japan showed, unconventional monetary policy, or QE, can also mean that central banks buy the asset class of equities. This provides liquidity to the market. In addition, higher share prices lead to a wealth effect and this may trigger consumers to spend more.
Markets tend to climb on a wall of worry. That means macroeconomic concerns are often not enough to cause a bear market. However, liquidity is a real concern and the lack of buying power in the market could give bears a field day. Once again, a lot depends on the actions of central bankers, next to oil prices. Investors should be very careful in this market and read our article “How To Survive A Bear Market” to be prepared…
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