stock strategy
Equity markets are undergoing a process of correction in prices that is largely driven by technical concerns and partly by fundamental factors. The correction began at the end of February with the initial nominal cause being a 10% fall in China A-shares. Whilst the fall in China shares is not in itself fundamentally meaningful, as Chinese markets had more than doubled over the previous year, it did highlight that equity markets had become frothy and it was easy to see a meaningful, sharp correction. Aside from a fall in equity prices, there has been a general reduction in risky trades. Emerging market and high yield debt prices have fallen, the value of the yen has risen after the yen had been the worst performing currency in the past year, and general volatility has jumped significantly.
Over the past 4 years there have been a number of equity market corrections, between 5-10% in developed markets, and 10-20% in emerging markets, which generally lasted 1 to 2 months. Each one had a different trigger at the time – Iraq war and SARS in 2003, concerns over China tightening in March 2004, oil price rising significantly in August 2004, downgrading of Ford and GM corporate debt to non investment grade in March 2005, and concerns over inflation and too much tightening by global central banks in May and June of 2006. Ultimately these corrections proved to be buying opportunities and despite the corrections equities managed to rise in every single year for the past 4 years. The key drivers of markets remain the fundamental forces of economic growth and market valuations. As long as economic and corporate growth remains solid and market valuations are not excessive, the medium term trend for equities will remain positive, despite the corrections.
Aside from the technical factors behind this correction, there are investor concerns over growth in the US. Investors are worried that the slow down in the housing sector could worsen. This could lead to mortgage defaults that could hurt the balance sheets of financial institutions. If this happens, banks may tighten credit conditions. At this stage, whilst there have been some problems in certain mortgages that were made in the hey-day of the US housing bull market between 2004 and 2006 to low quality borrowers with poor or non existent credit histories, the problems have not been wide spread. Moreover, it is not a problem for the US banking system as it is generally not involved with these kind of borrowers but some housing finance lenders
There has also been a slow down in global industrial production. This has been mainly driven by the need to work off excessive inventories rather than a problem with end demand. We expect that production activity will start to accelerate from the 2nd quarter. We do not expect significant problems in the global economy from either the US housing slow down or industrial activity. Interest rates globally remain at comfortable levels, economic activity outside of the US is solid and in the US consumer and business confidence remains firm and employment continues to expand at a good level.
In term of strategy, we hold our view on equity as neutral for the near term. We still consider equities as attractive as we remain positive on global economic activity. We expect some moderation of global growth this year, but it is likely to be mild and the risk of outright recession is very low. Valuation levels remain reasonable for markets against their own histories as well as other asset classes like bonds and cash. We thus do not expect that the bull market is over.
We expect that this correction may reach the magnitude of past declines and could last 1 to 2 months. We see the correction as a buying opportunity but some patience is required. We will prefer Asia as the region offers solid growth opportunity with attractive valuations. The European industrial sector also looks attractive as do US financials that have been sold aggressively on the back of mortgage concerns.
Recent Comments