To say it has been a difficult quarter for investors would be an understatement, with markets and investor confidence experiencing the most significant weakness for many years. We have all read and heard about the challenges facing China, and the implications for the global economy, but the issues are broader than just how China and the developed world copes with the former’s inevitable slowdown. As I write, the MSCI World index (total return) is down 8.3% in Q3 in US dollar terms, although given the sharp falls in some sectors, it sometimes feels worse than that.
Depending on one’s starting point, we are now some seven or eight years on from the start of the Global Financial Crisis (GFC). For what it’s worth, my reference point is the HSBC profit warning in February 2007 when it cut its profit forecasts due to the escalating bad loan experience in the then recently acquired US subprime lending division. Even if the crisis didn’t really start with a vengeance until 2008, history would suggest we are closer to the start of the next downturn than we are to the end of the last one.
The problem is that even with ultra-loose monetary policy with zero per cent interest rates and abundant liquidity from (effectively) global quantitative easing (QE), developed world economic growth is modest at best. On our forecasts, global growth is going to be only 3.5% in 2016, and will be much weaker than that in much of the developed world. In the US, the strongest developed market, growth forecasts continue to come under pressure, acting as a restriction on the authorities’ ability to start normalising interest rates. In Europe, growth could pick up but only to 1.5% next year, despite massive monetary stimulus, a much weaker euro, and a big fall in energy prices. Even in Japan, where QE is now running at over 14% of GDP per annum, growth and inflation are very hard to come by, with growth set to be no better than 1.5% next year.
This is why China matters so much; it has been such a significant driver of marginal growth. With credit-fuelled investment spending inevitably slowing down, or even potentially coming to a halt, the effects this has on the global economy and financial system are significant. For commodity prices, we have already seen the collapse in the oil price and in industrial metals more broadly as consumption has been curtailed. With new areas of supply for oil, and unwillingness by OPEC to cut production, the oil price has fallen to levels previously difficult to imagine. Although this is effectively a much-needed tax cut for Western consumers, so far they appear to be saving rather than spending their gains.
For the oil producers, the effects are potentially catastrophic, putting their budgets under enormous pressure and placing a spotlight on expensive (and now unaffordable) social welfare programmes. This in turn has placed downside pressure on many of the emerging market currencies, and many economies are being forced to implement pro-cyclical interest rate policies to protect their currencies from collapse. All of this is negative for global growth, and places the financial system under some pressure. How this will unfold is difficult to predict, but what we do know is that global economic growth forecasts will continue to be downgraded.
Why developed market growth is so weak, despite the numerous monetary stimuli, is difficult to explain. Maybe it is the invisible force of deleveraging as we grapple with the debt overhang built up during the ‘noughties’. Maybe it is unfavourable demographics or a lack of productivity improvements. Whatever the reason, a weaker China is bad news, because at the margin, its growth has been so important. One has to worry that, if global growth comes under real pressure, there is not much left that the authorities can do to stimulate the economy; interest rates are already at zero, QE has had a limited impact, and budget deficits restrict the ability of governments to spend their way out of trouble. Our central case is that China will slow to perhaps 5% GDP growth per year. This would mean we wouldn’t need to wait to find out what China does next on the policy front, as further major stimulus would probably not be required. Whatever the outcome, it seems clear that rates are going to stay lower for longer, and the end point for interest rates once they do start to rise will be much lower than in past cycles.
Before one gets too depressed, there is some good news resulting from this. After years of losing market share to passive providers, active managers are fighting back. This year in Europe and the UK, the average active manager is some 3-5% ahead of the index, and our own funds have mostly done better than that. Reflecting our cautious stance and investment style, we have been very underweight the large energy and resource stocks, and have observed as bystanders as the share prices of many once-mighty companies have collapsed under the weight of downgrade after downgrade. For those that are also badly financed, it could get worse from here, and one should expect some bankruptcies to follow. This has already been reflected in credit spreads, where high yield spreads have risen to nearly 600bps over gilts from a low of 300bps in 2014. In our opinion, robust stock selection, risk management and portfolio construction are going to be critical as the backdrop continues to deteriorate.
Thankfully, these are all areas where we believe we excel. Although we are now arguably in the most challenging macro and market backdrop since the onset of the GFC, we believe strongly that we are well placed to continue to deliver for our clients. We have been pleased with our performance versus our peers, and areas of weakness are few and far between. It is however a time for focus and vigilance, and we will be keeping that in mind at all times when managing portfolios.
Mark Burgess is CIO EMEA and Global Head of Equities at Columbia Threadneedle Investments.
