The recent “crisis” in global markets is reminiscent of 2008’s sharp declines, according to Coram’s James Sullivan, who says the backdrop may even be more dangerous today given the lack of safe-havens available to investors following years of ultra-low rates and quantitative easing.
Global equity markets have been on a downward trajectory since mid-April owing to a variety of concerns such as a spike in government bond yields, uncertainty surrounding the Greek debt negotiations and fears over China’s worsening economy.
However, Monday – or ‘Black Monday’, as it is now being called – turned out to be the worst rout in stock markets since the global financial crisis with poor economic data from the world’s second largest economy sparking frenzied selling.
The FTSE 100, for example, started Tuesday below the 6,000 mark meaning the blue-chip index is now down some 15.7 per cent since its peak in April this year. It has by no means been the worst performer, however, as the graph below shows.
Performance of indices since April 2015
Source: FE Analytics
Given the extent of the selling and the fact we are in a supposed ‘quieter’ time for markets, many believe concerns over a full-blown crisis are overdone and that a bounce back is on the cards.
However Sullivan, who recently set up Coram Asset Management following his departure from Miton, says that given the excesses of recent years in the form of ultra-low interest rates and quantitative easing, more falls are on the horizon.
While he says this could present a buying opportunity for long-term investors, he warns the current environment could be more dangerous than the one presented to investors in 2008 given all asset classes have been driven up together over recent years – leaving very few places to hide against further volatility.
“The volatility is reminiscent of 2008. However, the difference today versus 2008 is the lack of true defensive assets available other than cash. Historically, volatility proves to be somewhat self-fulfilling so it may continue,” Sullivan said.
The major concern predicating the huge falls has been China – thanks to the devaluation of the yuan and weaker than expected growth. Phillip Lawlor, chief investment strategist at Smith & Williamson, says there is now even a “subliminal concern” that the market is no longer convinced the authorities in China are keeping control of the situation.
“There is this chaotic fear that it’s all going to unravel at a record rate,” Lawlor said.
However, Sullivan says polices such as QE have compounded the issue, which is likely to lead to further bad news for equities.
“Movements of the like we have seen are reminiscent of 2008, and the intra days moves have been rather aggressive. These seismic movements do not occur very often, yet I fear due to the extent of QE inflating the market(s) beyond reasonable size, this is now par for the course. It has added another dimension to investing in the markets.”
Sullivan says that when you add other major global macroeconomic headwinds such as the prospect of deflation thanks to China’s slowing growth and devaluation (along with plummeting commodity prices) into the mix, it makes for even worse reading for an already overvalued equity market.
“The prospect of deflation is real issue, and this will eat into earnings like a hot knife through butter – and that is something that cannot be overlooked. China is pumping out deflation faster than we can say ‘forward guidance’.”
“With markets trading on elevated P/E multiples, deflation or a rate rise was always going to cause some unrest – so the starting point was never favourable. Throw in the acknowledgement that China is slowing down at a much faster clip than published, currency wars only just gathering momentum, and we have a rather toxic mix.”
He added: “So is this the tip of the iceberg or are we done? We suspect there’s more to come.”
Of course, investors have had to deal with major equity market falls in the past, most notably in 2008 when the likes of the FTSE All Share fell 30 per cent. During that crisis, however, investors did have ‘safe haven’ assets to flock to.
The most notable of those were gold and government bonds, as the graph below shows, which delivered double-digit gains.
Performance of indices in 2008
Source: FE Analytics
However, Sullivan doesn’t think that will be the case if the market backdrop were to deteriorate significantly from here as the distorting effect of extremely loose monetary policy has driven the prices of all asset classes up together.
“Without wishing to be alarmist, in previous bear markets we have witnessed bumps in the road that were just the precursor for much greater moves – and we can't be sure this isn't history repeating,” he said.
“One observational difference however, is the lack of obvious safe haven assets available today to use as protection due to the expense at which they are priced at. So we remain opportunistic and accommodating of risk, but also guarded against further deterioration of asset markets.”
Since the start of the year, for example, bonds, equities and gold have been tightly correlated and all fallen considerably at points due to various concerns.
Performance of indices in 2015
Source: FE Analytics
There have been a number of warnings about such an event, with the likes of Hawksmoor’s Ben Conway back in June that it had “never, ever been harder” to build a diversified portfolio given increasing correlations and high asset valuations.
“You cannot lose sight of fact that the current environment is unprecedented. These are ridiculous times, absolutely ridiculous,” Conway said. “You have to take a step back and you shouldn’t listen to people who claim they know how markets will perform because no-one knows how it is going to pan out.”
While bonds and gold have acted as an equity market hedge over the past week, FE Alpha Manager Charles L Heenan of the Kennox Strategic Value fund agrees that current market is potentially very dangerous.
“It’s been very interesting and I would have to agree [with Sullivan],” Heenan said.
“All asset classes seem to face their own different problems as there has been so much money pumped into the system over recent years which has been chasing the likes of property, more esoteric areas such as fine wine and art as well as bonds and equities.”
“All of these asset classes are trading at high levels and when everything goes up together, it is only rational to think they might go down together as well.”
Performance of indices since global financial crisis
Source: FE Analytics
“I find it fascinating that the explanation for all these falls is China as I think there are other drivers at work. I don’t think you get that sort of volatility without bigger stories going on and one of which is how QE has driven up most asset classes.”
Lawlor admits that investors seem to be between a rock and a hard place in terms of protecting their portfolio.
“It’s seems to be a bit of a Hobson’s choice, as you either have bonds which have incredibly low yields which could be vulnerable and equities which have fallen and become very stretched from a valuation point of view,” Lawlor said.
However, while bonds have maintained their position as one of the most hated asset classes for a number of years now, Lawlor says they may still be able to offer investors protection against equity market risk.
He says that the major reason bond yields didn’t fall dramatically during ‘Black Monday’ is because the fixed income market is waiting for confirmation that the US Federal Reserve won’t be raising interest rates in September.
Lawlor says if the central bank were to tighten monetary policy it would cause real issues for both bond and equity markets, though, so investors need to be aware.
However, similar to what FE Alpha Manager John Pattullo recently told FE Trustnet, Lawlor thinks the big deflationary forces emanating out of China (along with very low commodity prices) means the chances of a rate hike now are very low.
As a result, he is becoming more constructive on bonds.
“We had been very underweight bonds but we have moved towards a more neutral position over the past few weeks and that is because we had to acknowledge that deflation could come back. You cannot ignore bonds if deflation does kick in because they are the only place to go,” he added.
