Published in the Nikkei Asian Review 4/1/2016
The investment world enters 2016 with some trepidation. The extraordinary ascent in stock prices that began in March 2009 is now very long in the tooth. In most markets most stocks fell last year. The price of copper – known as “the only metal with a Phd” on account of its track record in foreshadowing the economic cycle – has been in free-fall, as have other commodities.
With the exception of the US market, world stock markets are inexpensive overall, but that disguises an unusual degree of internal polarization. Cyclical stocks languish overlooked and undervalued whereas many internet names, food manufacturers and purveyors of household necessities are trading at dizzying valuations.
The message is that almost eight years after the global financial crisis investors lack confidence in economic growth, yet seem blindly optimistic about the prospects of a select group of “recession-proof” companies. The world is a lot less predictable than this simple dichotomy implies. It will surely be tested over the coming year as several key market mysteries are unravelled.
DID YELLEN GET IT RIGHT?
The Federal Reserve has finally embarked on a long-anticipated tightening cycle. Or has it? Central banks everywhere are “data-driven” these days, which means they have no better insight into what the future holds than anyone else. It appears that the Fed was pushed towards raising rates by a couple of good employment numbers. And yet CPI inflation in the US in 2015 was close to 60 year lows and wage growth remains subdued, with the percentage of the labour force in jobs still at a historically low level. Crucially US corporate profits are declining at the fastest rate since 2009 which casts a shadow on the outlook for employment and capital investment.
A run of weak numbers and the tightening cycle could easily be suspended or even reversed, bringing an end to the rally in the dollar and laying the groundwork for rallies in emerging market stocks and commodities.
WHITHER THE YUAN?
To adapt Winston Churchill’s comment on Russia, today’s China is “a riddle wrapped in a mystery inside an enigma.” The explosive rise and then plunge of the A-share index, the stock market support plan that was suddenly withdrawn, the disappearance then reappearance of Guo Guangchang, China’s Warren Buffett – such bizarre twists and turns have become part of the world financial scenery. The biggest conundrum of all, though, is the yuan.
Up until November 2015, when the IMF was to revise the composition of its SDR (Special Drawing Rights) pseudo-currency, China had a clear incentive to keep the yuan stable versus the US dollar. Now, with the yuan having been given a 11% SDR weighting and national pride duly satisfied, attention is likely to turn to the economic fundamentals.
Over the last four years the yuan has appreciated 40% in real trade-weighted terms and deflationary pressures appear to be mounting. A further loss of economic momentum would strengthen the case for devaluation. A small adjustment in August 2015 was enough to send shock waves through the world’s financial markets in August 2015. What havoc might result if the Chinese authorities were to follow in the footsteps of Japan, the Eurozone and much of the emerging world and stage a large-scale currency depreciation?
A DOUBLE ELECTION FOR JAPAN?
After a testing 2014, Japanese Prime Minister Shinzo Abe strengthened his political position in 2015. He was re-elected leader of his own party unopposed and the largest opposition party has conveniently imploded. Next July the regular bi-annual election for Japan’s Upper House will take place. Abe has an opportunity to entrench his dominance by calling an election of the more important Lower House on the same date.
“Double elections” are historically rare. By definition they favour the ruling party, which can use all the policy tools at its disposal to create a feel-good atmosphere. Not coincidentally, they are also good for the stock market. The last example, in 1986, saw the market rally 30% in the six months before the election and another 20% in the subsequent six months. The previous example, in 1980, was less spectacular, with the Topix Index up 7% for the year.
There has rarely been a political leader anywhere in the world who has set such store in stock market performance as Abe. So far his faith has paid off, with the Topix Index recording four successive annual gains. The July election is particularly salient as a strong result could give him the dominance of the Upper House required to kickstart the controversial, but necessary debate on revising Japan’s pacifist constitution. With a place in the history books awaiting him, the last thing that Abe will want to see is a setback for the Abenomics bull market.
CAN COMMODITIES RALLY?
Nobody predicted the scale of the decline in the commodity complex and so it is fair to assume that, nobody will predict any recovery. Analysts’ forecasts of commodity prices are even less accurate than forecasts of stock prices. What can be said is that by historical standards the collapse in prices is already well advanced. In inflation-adjusted terms, the Thomson Reuters CRB Index has fallen 66% from its 2008 peak and has returned to the lows of the 1990s, well before China’s arrival as a major industrial economy.
Likewise, anecdotal evidence suggests the capitulation phase, when all hope is abandoned, is not far away. Mining major Anglo American recently announced a radical restructuring that amounts to a self-dismemberment. Goldman Sachs has ended its 34 year involvement in investing in mines and physical commodities and also closed its BRICS fund after years of poor performance. Meanwhile short-sellers stalk the fallen heroes of the boom such as Glencore and Noble.
All the talk of peak oil, peak commodities and a world running out of resources seems to belong to a distant era. But, remember, this is already water under the bridge. As ever, nobody has a clue what will happen next.
UNICORNS OR ROCKING HORSES?
Which takes us to the heroes of the last twelve months, which have to a large extent been the heroes of the entire QE (quantitative easing) driven bull market – those exceptional companies with bullet-proof franchises whose golden prospects into the long-term can be taken for granted. At least that is what the nose-bleed valuations imply. For the uptrend to continue such companies must beat ever more optimist consensus expectations. Doing just as well as expected will not be enough; doing slightly worse will have severe consequences. And if they stumble by the wayside or get out-competed, as often happens in dynamic market economies, the damage to investors’ financial health will be immense.
As Warren Buffett – the real, non-disappearing Buffett – once said “you pay a very high price in the stock market for a cheery consensus.”
This monkey can bite. It can steal your sandwich when you’re not looking. But treat it with respect and it could be your friend.