Financial markets are in danger of creating a ‘self-fulfilling outcome’ that will send asset values even lower unless common sense breaks out, says Robeco’s Lukas Daalder.
The worst performance for equities in a January for many years was based on flawed assumptions about China, oil and the high yield market, and could lead to a ‘boom-bust’ scare that will make matters worse, says Daalder, Chief Investment Officer of Robeco Investment Solutions (RIS).
He says the RIS multi-asset portfolio is keeping its nerve by maintaining its overall overweight to risky assets, though the team has taken some risk off the table by reducing the size of the overweight to developed market stocks, which have been hit hard in the sell-off.
“Developments in financial markets can spill over to the real economy, leading to a self-fulfilling outcome,” says Daalder. “We are not talking about the wealth effect of the stock market correction that we have seen so far – that’s of second order. The bigger risk is of a credit event that could lead to a (temporary) freezing up of credit markets. This can be linked either to the drop in oil, or to a strong (unexpected) move in financial markets.”
“The drop in oil can trigger a default of oil companies – which we think would not be much of a surprise at this stage ¬– or of oil-producing countries, which would be less anticipated. Sharp moves in financial markets can always lead to the demise of a hedge fund or – as we saw in December – of a fund manager (Third Avenue). These kinds of events can lead to the loss of liquidity, for example in the US corporate bond market, which in turn would put even healthy companies at risk. In such a scenario, the US economy can indeed slip into a recession.”
Daalder says it is unrealistic to expect human sentiment not to play some sort of role, since many investors active today would have memories of prior painful market turmoil. “But corrections happen more often than you think,” he says. “Now, this is certainly not an attempt to downplay what happened at the start of the year. We are the first to acknowledge that this has been a pretty painful period.”
“The point we are trying to make is that 10% and 15% drawdowns happen to be pretty regular events; the fact that this one happened at the beginning of the year holds no deeper meaning. Reading through the research reports, the newspapers and the blogs, we get the feeling that this message is sometimes lost.”
“But with all the talk of hard landings in China and recessions in the US, it is not surprising that certain investors are scrambling out of the market for fear of ‘the next big one’. The boom-bust fear is bigger than it was prior to 2000, which means that moves could easily be exaggerated compared to what we have seen in the past.”
Daalder also doesn’t believe in the supposed ‘January effect’ – the notion that a poor start to the year means the remainder of the year will also be bad. “There are many examples of weak Januarys which were followed by excellent returns later that year,” he says. “More generally, we would say it is the future, not January, that determines the fate of financial markets.”
“Having said that, there is no denying that a sell-off in January clearly feels different to a sell-off that takes place in – say – September. The close of the previous year is the anchor to which we judge the year as a whole; it is the year-to-date performance that most traders and investors wake up with each morning.”
‘It is the future, not January, that determines the fate of financial markets’
“Unfortunately, bad Januarys tend to stick in the memory of everyone. Headlines like ‘the worst start of the year since 1930’ – which was the case for the first week of trading of the S&P 500, for example – only help to trigger the feeling that we are experiencing something outspoken, something that has seldom happened before. But they’ve all happened before.”
“And from the pessimistic reports, the majority of investors may have the impression that we have just experienced the biggest drawdown since the 2007-2009 debacle. We haven’t. In the case of the US, the current sell-off is of the same magnitude as the one seen in September last year, and in case of the MSCI World, we saw comparable (and bigger) drawdowns in 2010, 2011 and 2012.”
Daalder says the underlying economic fundamentals – while not ideal – do not indicate impending recessions, and the premise that a low oil price is bad for everyone remains flawed. “From a fundamental perspective, the sell-off has clearly created opportunities,” he says.
“Markets have traded on the back of the ‘low-oil-is-purely-bad’ premise, which we continue to believe is a very one-sided way of looking at things. We do not believe that the US economy is on the verge of a recession, nor that the Chinese economy is collapsing, even though some have mistaken the Chinese stock markets to be a good leading indicator for the underlying economy. Financial markets have overshot; that continues to be our call.”
“Having said that, sentiment is very weak, and we are currently less confident that this over-reaction will end soon. Overall, we think that uncertainties have risen, which is why we also have decided to scale back our risk profile somewhat. As we feel the risk-reward trade-off for high yield is interesting at the current spread levels, we have lowered our risk by increasing our underweight to emerging market equities, and by moving developed market equity exposure into more defensive stocks.”
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