Research Team , 22 January 2016

It has been a difficult start to the year for equity markets around the world, with extreme volatility and currency devaluation in China, geopolitical tension and ongoing sharp falls in oil prices causing the strong rally we saw in late 2015 to swiftly unwind. The S&P500 was down 6.0% in the first week of 2016, the worst start to a year in history.

Summary of the key issues

  • There's a long list of things to be worried about at the moment, all of which are somewhat intertwined. The most prevalent issues are concerns over China and oil prices, although we can also cite subdued global growth, the end of easy money from the Federal Reserve, geopolitical tension and markets that are priced to perfection after a six and a half year rally.

  • China has been the market that has grabbed the headlines of late, falling 10% last week and taking the Shanghai Composite to almost 40% below where it was in June. However, we should remember that it was also up more than 150% in the year preceding that peak. Chinese shares are traded largely by retail investors, and high levels of speculation have exacerbated market movements.

  • While this isn’t a huge concern for global investors, what’s happening in the underlying Chinese economy is. As the economy slows, the authorities are allowing the Chinese currency to steadily decline in the hope of increasing competitiveness. When combined with the stronger US dollar, this is a major negative for many other parts of Asia and the emerging world. It is this dynamic we need to watch more closely than what is happening with Chinese shares.

  • Oil prices have been another important driver in the recent volatility. After falling another 10.0% this year to the low US$30’s, crude oil is the lowest in 12 years. Many people are betting on it going lower still, and until we see this key commodity find a bottom, it’s hard to see financial market volatility dissipating.

  • On a brighter note, it hasn’t been all bad so far in 2016 (in the developed world, at least). The first US jobs report of the year was a very strong one, with the 292,000 jobs created in December well ahead of expectations for 200,000. We also saw the latest manufacturing PMI for Europe hit the highest level in 20 months, with output growth and job creation up across every single European nation covered in the survey.

  • We should also remember that markets are coming off a strong finish to 2015, so some weakness isn’t a huge surprise. New Zealand shares were exceptionally strong late last year, with the 13.1% rise in the final three months representing the best quarterly performance since the second quarter of 2003. Additionally, in the final few days of the year US shares traded within 2.5% of their all time high (from May 2015)

  • The US quarterly reporting season begins this week, which could provide some direction for the market. Alcoa reports after the close on Monday, and financial heavyweights JP Morgan, Citigroup and Wells Fargo are all scheduled to report later in the week. Last quarter (3Q 2015), the S&P500 saw a decline in earnings of 1.4% compared to the same quarter a year earlier. This was the first decline in quarterly earnings since the third quarter of 2009.

  • This quarter (Q4 2015) is likely to be similarly lacklustre, with six out of ten sectors expected to see earnings declines. Energy and materials are again expected to be the weakest by far, with declines of 68% and 24% relative to the comparable quarter a year ago. The four sectors which are forecast to experience an increase in quarterly earnings are telcos, consumer discretionary, healthcare and financials.

Expectations from here and implications for investors

  • In terms of the outlook from here, we see further downside over the short-term before markets stabilise. When we saw a similar episode of China-related volatility back in July/August, US shares ultimately corrected 12.2%, before regaining some ground. The US market is currently 8.6% below its December high, and another 4-5% decline from here is our best guess of where we might begin to see some stability emerge.

  • The local market has held up much better than other markets in the wake of this sell-off, with the NZX50 down just 3.5% since the end of 2015. While we aren’t immune to negative international developments (particularly in China, our biggest trading partner), we expect this resilience to continue. While agriculture faces a challenging outlook, the local economy remains in better shape than many others around the world. The currency is in a relative sweet spot, interest rates are at record lows, tourism is strong and so is the corporate sector.

  • Market volatility increased sharply in 2015, but rather than being a short-term dynamic, we believe it is simply moving back to normal after a few unusually quiet years. While last week was a very volatile one by any measure, we expect to see generally sharp reactions to good and bad news from shares, currencies and commodities as the year progresses.

  • We believe the coming year will be a more difficult one for investors, driven by persistently low interest rates amidst very low inflation, rising volatility and numerous geopolitical risks. All of this will see lower investment returns from most asset classes. Against this backdrop, high quality bonds and companies that offer sustainable (and growing) dividends should remain well supported.

  • New investors should use periods of weakness (such as this one) to selectively accumulate quality holdings. Focus on local companies that will benefit from a weaker currency and add to global holdings in favoured regions, such as the US and Europe. In the case of the US, our expectation of a lower NZ dollar is a key part of our positive view. We remain most cautious on emerging markets, and believe developed markets are again likely to be a safer place to invest in 2016. We also see little recovery in commodity prices on the horizon, so remain wary of the energy and resources sectors.