A week is a long time in politics, and this last week has felt like a long time in financial markets: the first half of the week with plunges in equity markets worldwide, the second part of the week with a sharp recovery, both in equities credit and high yield. There were almost unprecedented swings on a daily basis – sometimes on an intra-day basis – in the trading of US 10-year Treasury bonds. It was a week that led people to ask a lot of questions about investment policy, the world economy, and the enormous spike in volatility. Before addressing those, let’s briefly remind ourselves that for a long time volatility has been extremely low. Until recently, the volatility of commodities, of bonds, of currencies and of equities has been, by historical standards, exceptionally low. Uncertainty presents itself in many ways. It’s rather like holding a beach ball under the water – when you let the beach ball go, it bounces up further. That’s what I think we’ve seen; that’s what we continue to see. The proximate cause has been a reconsideration of the race of economic growth globally. Interestingly, although much of the commentary has been on Europe, the sector volatility in the equities space and the bond market volatility has been far greater in the US, probably because it was a given part of everybody’s investment thesis that US growth is recovering strongly and it wouldn’t be long before the Federal Reserve (Fed) would be starting to raise rates.
The turning point came this week when a number of Fed governors said that they would not rule out further stimulus in the future, or that they are arguing the case for an interest-rate rise to be pushed further out into the future. The markets rallied around that. That’s a straightforward signal that global markets still need either price stimulus or quantity stimulus, or that they’re going to reset their valuation base very rapidly. We think that the valuation base has already been reset, because even if rates are going to rise, they’re going to rise quite gently. That was true before the last two weeks, and it’s truer now. The higher-yielding end, and the slightly riskier end, of the fixed-income complex really has got some considerable value in it, and it’s worth looking closely at exposures there.
By contrast, long-duration government bonds have rallied very strongly because they’ve been the only diversifier around, and are almost certainly overvalued. For equities, the case still remains that they are the asset with the real rate of return whereby corporate earnings, as we’re seeing in the current earnings season, and cash flows are rising, and the ability to reward shareholders to increase dividends and corporate activity still remains very much in place. At the centre of this somewhat disastrous last couple of weeks has been economics. This week, we will get a number of economic releases which will be closely scrutinised, particularly on Thursday, when Japan, China, France, Germany, the Eurozone, and the US release their purchasing managers’ index figures for October. The market will examine those numbers very closely. It will also examine China’s figures on Tuesday for investment retail sales and third-quarter GDP. All the evidence suggests that the government in China is working overtime to ease policy on housing and the availability of credit at this stage, partly to meet the 7.5% GDP target the central government has set, and partly because they are probably concerned that things are slowly down too fast. Over the next few months, we expect a cyclical, but not a secular, recovery in the low levels of Chinese output led by upgraded activity in the housing market. We’ve also got a series of corporate earnings this week: from the pharmaceuticals sector, Glaxo, in Europe; from the banking sector, Credit Suisse, in Europe; and consumer plays such as Daimler and Amazon and, finally, Caterpillar. The latter will paint a picture of very considerable traction in the demand for global construction equipment. The reason for focusing on that is that it leads one back to the epicentre of the change in views about the economic outlook, which has been filled with disappointing numbers from Germany. We believe that the European economic outlook is very flat, but that there will be some cyclical improvement in numbers over the next six months. Fiscal easing and a little bit of policy change will help things along. We believe that the overselling of cyclical stocks in the stock market has provided a deep valuation opportunity.
Fortune could favour the brave
In summary, volatility has come back; it’s probably risen too far. Economics are low and flat, but in some areas they are going to improve relative to quite low expectations. Positioning has been flushed out quite a bit. There is some good value at the longer end of high-yield and emerging-market debt as a consequence of recent events, and for those who want to be brave, deeply cyclical shares have fallen so considerably in value and might just be positioned for a bounce-back.
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