Riding The Storm To Safety

Rainbow over clearing storm clouds


Andrew Milligan

11th March 2016 at 2:48pm

After a rocky end to 2015, the start of 2016 has done little to improve investor sentiment.

In January alone, market volatility returned with a vengeance: the S&P 500 stock market endured its worst first week of a year ever while oil prices fell to new lows.

Meanwhile, China continued to be at the epicentre of global financial stresses. Late February and March have, however, seen a marked rally in stock markets.

Looking ahead, policy decisions look key. We can see that further action by central banks to stimulate economic activity is likely to be inevitable in some countries, although others may prefer to batten down the hatches and wait for the storm to pass.

Shock stimulus from European Central Bank

In moves that surprised many, in March the European Central Bank (ECB) announced further stimulus to help boost the flagging eurozone economy.  The package of measures was more radical than investors had expected and markets oscillated on hearing the news.

Among other things, ECB president, Mario Draghi, revealed that main interest rates would reduce to 0% from 0.05% and its quantitative easing policy would be expanded to €80 billion a month, a leap of €20 billion.

The changes have been introduced to try to stop the eurozone from slumping into a potential period of deflation. Draghi pointed to continuing negative inflation rates and lower global growth prospects as reasons for the amendments to previous forecasts.

Oil storm: will it return to safe harbours?

In January, we explained the importance of falling oil prices, largely due to oversupply plus concerns over global growth. However, in recent weeks, the prospect of a deal between major exporters to cut production, along with signs of lower US shale output had caused crude oil prices to rally more than 25% from their earlier lows. In recent days, Brent oil has recovered close to $40 a barrel.

The Organization of the Petroleum Exporting Countries (OPEC) still believes that demand for oil will grow by 1.25 million barrels per day in 2016, though this is marginally less than its previous forecast.  Whether the proposed production deal will still go ahead, and what the impact will be if it does, is a matter of considerable debate.

When oil prices began to drop in 2015, the consensus was that global growth would accelerate. Instead, activity slowed last year and prospects for a sharp improvement in 2016 look dim.

So what went wrong? With the benefit of hindsight, we can see that the beneficial effects on consumers have been offset by the extent of the pull back in energy investment. In addition, the global economy in general and emerging markets in particular have been seriously affected by China’s slowdown and the extent of the fluctuations in the US dollar.

Distance grows between emerging and developed markets

This environment has proved painful for countries and companies with large commodity exposures and high levels of corporate debt. Financial stress is most acute in emerging markets, but developed market economies have not been insulated from these problems, for the following reasons.

  • The trade links between emerging and developed markets have increased substantially,
  • Companies in developed markets with high exposure to commodities have borrowed heavily,
  • Consumers in developed markets are more cautious, which is limiting the potential kick to growth from lower oil prices.

So what is the end game? Fortunately, much emerging market dollar debt has a long repayment term, emerging market countries have substantial foreign exchange reserves, and commodity debt in developed nations is a small proportion of total debt. Because of this, we think there is little likelihood of a universal emerging markets crisis.

Policymakers in Japan are analysing risks to growth and inflation. In response, the Bank of Japan surprised markets with a move into negative interest rates. However, further steps to stimulate its economy may be inevitable.

Recession is an ugly word

Signs of slowing growth and rising financial stress have cast doubt over the outlook in the US.  As financial stress continues to escalate, the dreaded “R” word is being debated by many investors and analysts: might the US economy be heading for recession this year?

We’ve examined it in detail and believe it was unlikely that the US economy was in recession in January. But the question remains, might it be heading there? We don’t think so. But, we do expect growth to slow in 2016.

In the meantime, we expect the Federal Reserve to delay further interest rate hikes until the financial fog clears, probably in June.

Closer to home there have been few signs of new policies from the Bank of England, which seems content to bide its time. A glance at the current economic environment explains why.

The UK is still growing solidly, although the pace of the upturn has undoubtedly slowed.  Household consumption has been resilient as incomes are boosted by low inflation. However, there is a risk that consumers could decide to save rather than spend – psychology will become more important into the summer.

Overall, the Bank of England is watching the economic outlook carefully: continued robust consumer spending and business investment would help allay fears that a more serious slowdown is on the way.

It’s important to remember that financial markets are constantly moving and changing, and various factors could potentially lead to more or less financial turbulence during 2016.

While there are areas of value to be found in financial markets and asset classes, at Standard Life Investments we believe investors should remain selective in their decisions about where to invest. We also maintain our view that a well-diversified portfolio should provide an element of protection.

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The information in this blog or any response to comments should not be regarded as financial advice and is correct as of March 2016.