INSIGHTS

MARKET OUTLOOK: WHAT WE’RE WATCHING IN Q2

Mark Lister, 21 April 2016

We have seen a significant rally of late, particularly in the sectors that were sold off heavily earlier in the year. For example, emerging market shares have rallied more than 20% since January lows and oil prices are up 30% (although both remain well below 2015 highs).

However, we are sceptical of how sustainable this rebound is, particularly for markets where fundamentals look challenging. Global growth looks lacklustre, China is facing further economic challenges, commodity markets are not yet in balance and deflationary risks remain.

market outlook what we're watching in q2

Manufacturing indicators have weakened recently, with China continuing to contract and conditions in the US manufacturing sector sharply falling. Japan and Europe remain above break-even, although both have eased from recent highs.

We believe markets will be stuck in a trading range until some of these headwinds are resolved. At present, we are at the upper end of that range. We still see opportunities to generate returns against this backdrop, although more defensive assets may be the best place to achieve this.  Some of the key issues in markets we are watching at present are:

  1. Oil prices. The oil price remains low, although it has recovered to circa US$40 from under US$30 earlier in the year. Lower oil prices provide a windfall gain for many economies, industries and consumers. However, there is also a negative side to the sharp falls we have seen. Not only is such extreme volatility disconcerting for investors, it also raises questions about the ability of many energy companies to repay debt obligations. This has added to worries in credit markets and dented sentiment toward banks that have lent to the energy sector. Another negative is the impact of falling capital spending on other parts of the economy, as those involved in the industry aggressively cut planned investment. Finally, as the oil-producing nations of the world face declining revenue, they too may pare back spending.  This has been a factor in the recent fall in dairy prices.
  2. Mixed global economic data. Economic data has certainly been mixed this year and while there have been some bright spots, the general trend is one of slowing global growth. The US manufacturing sector looks to be in recession, while December quarter GDP growth was well down on the previous quarter (albeit above market expectations). In contrast, the US labour market continues to look solid, while retail sales have rebounded strongly of late. Europe continues to grow from a low base and in many ways still looks to be a bright spot, despite some obvious challenges.

market outlook table

Global growth forecasts have declined over the past year in most regions, with Japan and Europe the exceptions.

  1. Ongoing concerns about the Chinese economy. Most indicators point to a sharper slowdown in China than many have expected and uncertainty regarding what is really happening on the ground remains high. While we still believe in the long-term story for China, our immediate view remains much more cynical.
  2. US Dollar. A strong US dollar is creating headwinds for US companies. Over the past 18 months, the US dollar has risen almost 20% against the other major currencies of the world. This has been a positive for exporters to the US, those who sell their products in US dollars and those who have invested in US equities. However, it has made life difficult for many US companies and has effectively tightened monetary conditions.
  3. US interest rates. The Federal Reserve increased interest rates in December for the first time in nearly a decade. A further four rate hikes were planned for 2016 (which would take the Fed Funds rate to between 1.25% and 1.50%) however, from the beginning the market has been less convinced about whether this is achievable. Expectations of further rate hikes have been declining as the economic backdrop has weakened, oil prices have continued to fall and market volatility has increased. Some market participants now see little chance of even one interest rate rise, let alone four, and uncertainty around how the Fed will approach the next several months has added to market volatility.
  4. Market valuations. Many of the major markets reached all-time highs in 2015 and valuations were looking stretched following several very strong years of returns. US shares were approximately 5% above their long-term average PE ratio during the year, while European and Australian shares were closer to 15% above their long-term average. These overextended valuations no doubt contributed to the quantum of the decline we saw earlier this year.

Action points for investors:

Existing investors should pay particular attention to their asset allocation and security selection. At the same time, periods of weakness, as we saw in January and February can be opportunities to consider some selective buying.