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Don’t get caught in the headlines

On 20th January, the FTSE 100 fell 3.5%, taking it 20% lower than its high in April 2015, which constitutes a “bear market”. But there are signs now that the markets might have fallen too far. Also, with inflation being pulled down so low, the costs of essentials such as energy and food have fallen creating an increase in household spending power.

China

So what is behind the fall? For over a decade, the Chinese economy has been growing at break-neck speed, reaching as much as 14% annual growth in 2007 according to the World Bank. More recently it has come down to around 7% annual growth, which contrasts with 2.9% in the UK, and around 2.5% in Germany and the US. Even if Chinese economic growth fell to 5%, it would still be expanding by the equivalent of the entire Swiss economy each year.

Chinese growth was powering the global economy and doing so just after the financial crisis of 2007. As the Chinese economic growth has slowed and its focus has shifted away from export-led infrastructure and manufacturing, and towards services and domestic consumption, demand for resources and products from international suppliers has dropped sharply.

The economic growth pushed the value of the Chinese currency, the yuan, up relative to the dollar. However, with the slowdown in economic growth came downward pressure on the yuan, to the point that the Chinese policymakers have been maintaining its relatively high value to the dollar by buying the yuan in Hong Kong. International markets were happy with this policy because it stopped Chinese exports from falling in value which would make Chinese products cheaper abroad, undermining the demand for products from competitive companies from other countries. This would create a knock-on effect of either suffering reduced demand or profits, or the other countries reducing the relative value of their currencies in turn.

This beggar-thy-neighbour process of currency devaluation creates uncertainty, deflation and lower demand all round. Instead of spending money, people wait while the price falls, so companies don’t invest because their profits are falling. That combination fundamentally undermines global economic stability and growth.

In August of last year, without warning, the Chinese allowed the yuan to fall by 3.5% relative to the US dollar. The rest of the world panicked thinking that this was the beginning of a full devaluation. It wasn’t, but it took markets months to recover the losses that were incurred and signalled the level of nervousness and sensitivity to the value of the Chinese currency.

New oil supplies

At the same time, new supplies of oil were being brought to market from sources such as shale oil, tar sands and fracking. In the past, the Organisation of Petroleum Exporting Countries (OPEC) would adjust how much oil it supplied in order to keep the price of oil relatively high so that oil producers could make profits without causing too much pain to their customers. This time, the de facto leader of OPEC, Saudi Arabia, decided that they didn’t want to risk losing customers to American and Russian suppliers and, therefore, maintained the same levels of oil supply. This forced prices of oil down, which brought inflation down to near zero levels.

So the Chinese economy has reduced its demand for capital and consumer goods, the oil price has fallen, taking inflation with it, commodity-producing countries and companies have seen their revenues collapse, and sovereign wealth funds have been selling huge tranches of the investments in shares and bonds to make up the shortfall in their revenues.

All of this affects the UK, and after eight months of falling prices, the FTSE 100 has entered into “bear” territory by falling a total of 20%. So how much of it is sentiment and how much is fundamentals?

Prices near bottom

There are signs that the negative sentiment has driven share prices too far down. The real price of oil is far from its all-time lows and Iran is back in the game.

However, in an article in the Daily Telegraph this month, it was reported that Russian oil companies are likely to cut crude oil shipments by 6.4% over the course of 2016. That equates to around 460,000 barrels a day (b/d) which would offset any additional oil from Iran’s return to the market.

Also, the falling prices have reduced capital expenditure in the sector by around 30% so, while there is a surfeit of oil at the moment, once demand does pick up it will take time for the idled wells to come back on line and that would put upward pressure on prices.

No one knows how long that will take, but we anticipate oil prices stabilising and increasing through the course of the year back above the $40/barrel mark or higher.

Energy stocks have taken a hammering as well but, as Chart 2 shows, they are now very close to their all-time lows. The FTSE 100 and FTSE All Share indices both have a substantial proportion of energy-related stocks and have suffered as a result. However, if these stocks are nearing the bottom then not only would their growth directly boost the indices, it would also raise sentiment which would be likely to lift shares across all sectors.

Increased spending power

In the meantime, falling oil prices act as a boost to real income in major economies including the US, the UK and Japan. Taking the UK as an example, the price of a litre of petrol has fallen from £1.42 in April 2012, to £1.01 in January of this year according to data from the RAC Foundation. The Daily Telegraph reports that, since January 2014, electricity and gas prices have fallen 34% and 53% respectively. In addition, food prices have been falling steadily since early 2014, according to Trading Economics.

That’s a considerable increase in real wages i.e. spending power. As the essentials get cheaper, people have more money to spend, save or invest in other things. And that’s before any allowance is made for the fact that the money in your pocket probably has been taxed, so a £1 reduction in petrol expense is worth, say, £1.20 in gross salary increase.

In Japan, corporate profits are high and companies are sitting on substantial cash reserves that they can use to expand the payroll or invest in plant and machinery. In the US, the latest three non-farm payroll data have been positive, indicating a rise in demand for job applicants which could lead to upward pressure on wage growth.

Increased spending power tends to lead to increased spending. In the UK, retail consumption accounts for around two-thirds of the economy, so the increase in real wages is a distinct positive.

A buying opportunity?

Finally, downward markets can take share prices below intrinsic value. This has already happened in Hong Kong where the Hang Seng index has fallen below net asset value for the first time since the Asian crisis in 1998. However, some investors see a bear market as a buying opportunity as prices are forced down sometimes beyond intrinsic value. But there are risks. The financial markets can provide a leading indicator of what the economy as a whole is going to do. So if the economy does follow suit and contract, then the markets will have further to fall.

Conclusion

Our investment philosophy is for the long-term. We’ve seen these market upsets before, they constitute an inevitable part of investing. Warren Buffett, the investment billionaire, is well-known for his approach of buying and “holding for at least ten years” and we agree. Why? If you buy and hold for one year, you have a 77% chance of making a positive return. If you buy and hold for ten years, that increases to 99% (source: Lipper, January 2016). So when investing, it is wise to investigate the evidence and make sure that decisions are based on research, sound reasoning and an appropriate time horizon.

Important Information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this report are our in house views as at 21st January 2016 and should not be relied upon as fact and could be proved wrong.

The information contained in this document has been derived from sources which we consider to be reasonable and appropriate.

This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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