The new year is still only a couple of weeks old, but already it is starting to look and feel rather different from the environment that we experienced in much of 2014. There are five key trends which have emerged so far in 2015. First, moderately weak equity markets, although this is more evident in developed than in emerging markets; second, weak commodity prices, with a sharp fall in the copper price last week coming off the back of an oil price that is still declining; third, lower-quality high government bond yields in the US as well as Europe; fourth, wider credit spreads; and finally, a much higher level of volatility in financial markets. These are the patterns that we would expect to see in the event of a material global slowdown in economic activity, or even in a recession.
So the key question for investors at the moment is whether markets are getting it right in appearing to price in much weaker growth expectations. Or is this just some erratic market behaviour, which sometimes happens at this time of year? Now to get this one right, it is important to review some of the recent key market developments which have brought about this shift in behaviour. This includes a number of factors: for example, some weak economic data and corporate reports from the US, in particular falling retail sales and inflation, lower manufacturing business sentiment, rising unemployment claims, and also, importantly, some disappointing financials results in the early stages of the current reporting round. Second, we’ve seen some potential financial dislocations caused by the collapse in oil prices, as in the high-yield market. Third, there have been concerns that the weakness in commodity prices is signalling a frail global economy both at present and going forward. The next factor is the potential for quantitative easing in the eurozone, which is likely to be announced this week. It is a reflection of the inevitability of a period of negative inflation in Europe, and a still less-than-stellar macro background. Another factor is the pending Greek election result, which could lead to additional tensions. And finally, the unpegging of the Swiss franc last week may not have broad global implications, but it is another example of the sort of challenge that markets have had to come to terms with in recent weeks. At the same time, there has been a dearth of unexpectedly good news to provide some welcome relief.
The fall in the oil price has resulted in some very material income transfers
Recently, we suggested that volatility was likely to be more a feature of 2015 than we’ve seen in years past, but this is not to say that all of the themes of the past couple of weeks or so are set to persist. Importantly, we would remain sceptical of the claim that the global economy either has been very weak, or is about to weaken. On the contrary, global economic growth in the second half of last year was the strongest it had been in some time, and we would characterise the more general tone of recent macro data as being quite trendless, rather than indicating material acceleration or deceleration – although the larger emerging economies do continue to struggle. While US financial earnings have indeed been disappointing in the current reporting round, the non-financial companies that have reported so far this quarter have, on average, displayed very robust earnings growth. The oil price is crucial here: the fall in the oil price has resulted in some very material income transfers from oil-producing companies and countries to oil users. To date, the pain being felt by the first group is very visible, and markets have reacted quickly to it. Look at the extreme underperformance of equity markets of commodity-related companies, the underperformance of energy-related high-yield companies, and the drop in the Russian and Brazilian currencies. But ultimately, the fall in oil prices should prove very beneficial for the global economy as energy users react to what is, in effect, quite a substantial increase in their real incomes. That should support spending. And this supportive impact is likely to become increasingly apparent in the coming months. Also, the recent Swiss and Greek challenges to the investment environment in the eurozone should not be seen as inevitably destabilising. In particular, even if Syriza does come to head a new coalition in Greece after the election, their stated policy is for Greece to remain in the eurozone, and some compromise over the degree of austerity is likely to be reached with the Troika even if the negotiations prove difficult for a period.
So recent weeks, for us, do provide a helpful guide to the rest of the year, because they highlight the range of challenges which the markets are having to deal with, and will continue to have to deal with. However, our central case is that these difficult first two weeks of the year will not be a good guide to risk-asset activity going forward. We would expect, on balance, better risk-asset performance than we have seen recently, largely because the weakness in the global economy that is currently being signalled by markets, is, we believe, unlikely to materialise.