James Bevan: A correction and nothing worse

Although the down moves in global equity are upsetting, the key issue for investors is whether the latest fall in prices are likely to be followed by yet another relief rally, or whether last week’s stock market rout is the beginning of a bear market.

Our view is that equities exemplified by the S&P500 are in a secular bull phase and we still look for progress to around 2150 by the end of this year, and 2300 next year, accepting that we will likely see the first ‘correction’, defined as a decline of 10% or more, in the S&P500 since 2012. But we can also recognise that this could it turn into a bear market with a decline of 20% or more.

One feature of the bear case is the technical picture, with the S&P500 off 5.8% last week to 1970.89, ending the week 7.5% below its record high of 2130.82 on May 21, when it was up 2.6% year to date (YTD).

It is now down 4.3% YTD and 5.1% below its 200-day moving average, and has been in a tight range of 2040-2130 since early February. On Friday, it closed at its lowest level since October 27^th 2014.

By way of context, there have been lots of panic attacks since the start of the bull market in early 2009, with the first four occurring from the second through the fourth years of the current bull market.

They were fully-fledged corrections, triggered by worries that recession was imminent, with anxiety focused on a double-dip in the US, disintegration of the Euro area, and a hard landing in China – each having the potential to cause global recession, either individually or in combination. When those fears dissipated, relief rallies ensued.

Euroland
This year started with concerns that the Greek/euro challenges would destabilize Euroland, but that issue seems to have been resolved benignly for now.

Earlier this year, there were concerns about a soft patch in US economic growth that is no longer an issue either.

The latest selloff was mostly triggered by the relatively small devaluation of China’s currency two weeks ago. That’s heightened fears that China’s economy is in much worse shape than had been widely recognized – and Friday’s release of the the Caixin/Markit Manufacturing PMI (MPMI) survey for August, which revealed a drop to 47.1, the lowest since March 2009, has fueld the worries.

Bear markets are caused by recessions when corporate profits decline along with the economy. Specifically, bear markets occur when forward earnings and forward P/Es decline during recessions. Corrections (and less severe panic attacks) occur when the P/E drops while forward earnings continue to move higher.

That’s what is happening currently, and even with a hard landing in China, it doesn’t look like we have the conditions for a genuine bear phase.

For sure volatility has risen hard, with the VIX jumping to close the week at 28.0, the highest since late 2011 and the biggest weekly jump on record. But despite the intense risk-off moves in stock markets around the world, there hasn’t been a flight to safety, with the US 10-year yield falling 15bps last week to close at 2.05% whilst the yield on the Merrill Lynch high-yield composite rose 21bps last week to 7.38%. NYSE trading volumes last week averaged 4.5 billion shares, only modestly from the 4.2 billion traded the week before.

Past crunches
In the past, credit crunches have often been the cause of recessions but the increase in yields in the junk bond market is mostly attributable to the energy sector, which accounts for about 17% of the market. With the Fed Funds rate near zero, and reducing probability of a tiny rate hike in September, credit remains amply available and cheap, especially to fund more buybacks and M&A.

Equally, it’s hard to worry about a credit crunch in Euroland with the ECB committed to buying lots of bonds every month through September 2016.

In contrast, China’s credit markets may be tightening, especially in the so-called shadow banking system. Last week the FT reported that eleven shadow banks had written an open letter to the top Communist party official in northern China’s Hebei province asking for a bailout that would enable the bankrupt credit guarantee company to continue to backstop loans to borrowers.

If the guarantor cannot pay, it could spark defaults on at least 24 high-yielding wealth management products (WMPs) – but the chances are that the government will provide a bailout to avoid raising concerns about China’s credit system.

Creaky
Contributing to the stock market’s latest anxiety attack are fears that central banks are running out of tools to prop up their fragile and vulnerable economies and creaky financial systems.

Actually central banks can undertake more Quantitative Easing, and Minneapolis Fed President Narayana Kocherlakota wrote in the WSJ that “The U.S. inflation outlook…provides no justification for policy tightening at this juncture.

Given that outlook, the FOMC should ease, not tighten, monetary policy by, for example, buying more long-term assets or by reducing the interest rate that it pays on excess reserves held by banks.”

Meanwhile the PBoC has plenty of room to cut required reserve ratios, which were lowered from 20.0% during January of this year to 18.5% currently for large banks, and has room to lower the prime lending rate, which is down from 6.00% late last year to 4.85% currently.

Tough transition
China looks to be experiencing not a hard landing in its overall economy, but more a tough transition from manufacturing-focus to services-focus.

Manufacturing has been driven by exports and spending on infrastructure, but now there’s excess capacity, but expanding services should more than offset weakness in manufacturing.

This upbeat view chimes with the IMF’s annual survey of China, out in August which said “China’s growth is expected to be 6.8% in 2015, down from 7.4% last year.

This slowdown, in line with the government’s target of around 7%, reflects progress in addressing vulnerabilities, especially a needed moderation in real estate investment.

The recent stock market correction will not derail the ongoing adjustment to a slower yet more balanced growth path.

Since the global financial crisis, China has relied on an unsustainable growth model of excessive credit and investment, which has created large vulnerabilities in the fiscal, real estate, financial, and corporate sectors.

Moving to a more sustainable growth path requires reversing these trends. In most areas progress has succeeded in slowing the pace at which vulnerabilities rise.

Further progress is needed to put vulnerabilities on a downward path, including a decline in the level of residential real estate investment, multiyear deleveraging to help close the credit gap, and medium-term fiscal consolidation.”

Emerging markets
It’s much harder to be an optimistic contrarian on Emerging Markets (EMs) and many Ems are facing a hard landing, especially those that produce commodities.

The CRB raw industrials spot price index and the Emerging Markets MSCI stock price index are both well down. But weaker commodity prices are helpful for many economies.

And while a global recession is certainly possible if some terrible “unknown unknown” happens, the latest M-PMI out of Germany suggests that the world economy is still growing well enough to boost the country’s exports, even if the ECB stimulated them by depreciating the euro.

Markit Economics reported on Friday that Germany’s MPMI had risen from 51.8 in July to 53.2 in August, the highest since April 2014.

Equally, the Markit/Nikkei Japan MPMI rose from July’s 51.2 to 51.9 in August, and the index for new orders rose to a preliminary 53.2 from a final 50.9 in the previous month.

This is the fastest growth in seven months and suggests that domestic demand is improving. That said, the flash index for new export orders fell to 50.5 from 52.2 in the previous month, suggesting that overseas demand is losing momentum as China’s economy slows, and the output component of the MPMI index also fell to 51.9 in August from July’s 52.2.

Challenge
One real challenge for stock markets has been valuation levels and last week, the forward P/E of the S&P 500 fell from its high of earlier this year to a new low for the year of 15.5 times and meanwhile, as of last week, forward earnings have clambered back up to 127.72.

Whilst there’s the risk that lower oil prices and a stronger dollar dent earnings, these numbers point to the resilience and diversity of the US economy, and by limiting the risk of a serious spike in prices, the equity bull market may end up with a longer run, even if market behaviour over recent days has been very upsetting.

One of the key reasons why credit crunches and recessions kill bull markets is that they dry up the availability of financing and cash flow available to fund buy backs, as well as M&A. This is particularly important now because this bull market has been fuelled by corporations buying their own shares and more recently buying the shares of other companies through M&A.

At $1.2tn, M&A volume in the US is on track for a record year, and acquisitions have been the driving force behind a record pace $925bn of investment-grade debt issuance, with likely around $95bn more bonds sold this year to finance takeovers.

The additional supply is one reason why investors are demanding 1.64% points above benchmark government rates to own investment-grade notes, the highest since July 2013. But this backup in yields need not slow the pace of buybacks and M&A, and yields may well move lower if the FOMC decides at its September meeting to postpone any rate hike given the recent turmoil in the financial and commodity markets.

It may well be a large corporate deal that re-ignites bull sentiment, and just for noting, there is a remote political threat to buybacks with Senators Warren (D-MA) and Baldwin (D-WI) thinking that stock buybacks are bad and that the SEC should forbid them as market manipulation. We’ll keep a beady eye on any and all developments.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

* CCLA is a supporter of Room151