It is a hackneyed phrase that everything seems to move faster now than it did in the past (unless of course it is me on the Saturday morning Parkrun), but there is genuinely an argument for rolling it out now to describe the first few weeks of this year. The slowing down of Chinese economic growth – which, to be fair has been taking place for over two years now – has reached a point where it has triggered a tsunami of fears over what the “new normal” for the Chinese economy is, and what implications that has on financial stability in the region and the ongoing demand for basic raw materials. Investors are frantically trying to get ahead of the second and third wave effects of these ructions.
To some extent, we are already seeing the second wave impacts in the UK. The first flurry of activity in UK markets was focused predictably in the large, global industrial names particularly in the oil and mining space. As the largest global consumer of basic raw materials, clearly any major slowdown in activity in China will have ramifications for both volumes and prices. That the support industries surrounding major extractors of raw materials should also be under pressure is equally not a surprise. When investors’ sentiment is rattled, the first port of call in raising liquidity is normally again in those larger companies where it is quickest, easiest and normally cheapest to sell equity investments. So it was unsurprising that in the first few days of the month, on a relative basis mid and small caps outperformed their larger brethren. Yet, in recent days that trend has turned. There is a second wave follow through of selling activity into the mid and small cap space. There is some anecdotal evidence that this is being caused by the requirement to meet fund redemptions in an area of the market that has held up remarkably well over the last year. It is also in response to some more cautious trading statements from some domestic consumer facing businesses that struggled over the Christmas period. The small and mid cap space has a relatively large amount of these in its universe.
So, across the board now, there is much more scepticism over what is exactly the right price to pay for equity. Yet it is still very much being applied sporadically. There remain parts of the market where the (perceived) assurance of earnings delivery is worth paying up for.
All of this is making this stock market very interesting – and more quickly than we anticipated would be the case. Share price responses to muted trading statements have been harsh. In many cases, share prices in businesses with high yields are assuming that these dividends will not be paid out in full. Whilst a lot of this analysis will be justified, many businesses will pull through this period more or less intact. And we are now setting our sights to that possibility.
Despite the falls in share prices, we are not yet calling the UK market “cheap”. For now, we will confine ourselves to saying that a lot more companies are piquing our interest as potential new investments. Yes, some of these situations are a bit like trying to catch a falling knife – so a certain amount of circumspection is required. But buying when other investors are close to capitulation is normally a winning tactic.
Looking at the economic fundamentals affecting the majority of our companies, the world simply is not that bad. Yes, China remains the largest potential systemic risk to equity markets, but slowing growth should not slip further into no growth. By contrast, in the United States, the labour market grows ever more robust – which will eventually lead to sustained wage and consumption growth. One sometimes forgets that despite its size, the US economy is quite insular, and unlikely to be massively impacted by a Chinese slowdown. In the UK a similar picture exists for its labour market, and with near universal promotion for new house building, the short term outlook is reasonably robust. Even in the European continent, a year of quantitative easing is finally growing the money supply again – a decent lead indicator of economic growth. From a UK perspective, the strength of Sterling relative to major trading currencies since 2013 has reduced competitiveness abroad and the value of overseas earnings. However, Sterling has fallen by circa 10% against the US Dollar and the Euro since the summer of last year – offering a tailwind to exporters and overseas earners alike.
We would love to report that we will be fully invested by the end of the first quarter, or once the market hits some arbitrary index level. But, we can’t. This process will be entirely dependent on the individual stock ideas that we engage with. What we can say is that in the coming weeks many companies will clarify their short term trading prospects when they announce their full year results for 2015. In many cases, this will rebase expectations for 2016. When this happens, share prices will be rebased even further. But only a small part of a business’s value is dependent on current year profits. The vast bulk if its value is driven by its growth and return on capital over a whole cycle, which in turn is driven by its market position, the strength of its customer franchise and its discipline over allocations of capital.
Even now, these factors change only very slowly.