Well the New Year’s here and we’re not off to a great start. Equity markets have recorded their worst ever start to a calendar year. And this comes on the back of calendar 2015 performances which in price terms were negative for most major equity market indices – and those that did record positive performances were mostly in the low single digit range.
Why the reason for all the carnage?
That age old enigma – China (and the associated effect that this is having on the resource sector slide), which we were onto this quite early. In June last year, as part of our Investment Committee operations, we wrote a discussion paper titled ‘The Next Asia Crisis’. It detailed the deteriorating balance sheet situation in China and the ramifications that this would have for a (then) skyrocketing Chinese equity market and fragile Chinese economy. Much discussion was had and not all agreed when we presented this view, but as early as August 2015 our fears were soon realised – careful what you wish for.
So has the recent market upheaval taken us by surprise?
Well, yes and no. It’s a little like knowing that someone is hiding in a closet but when you open the door you still get a frightful shock anyway. Our thesis has increasingly been that we are now in the more mature stage of the investment / credit cycle (the decision to taper monetary accommodation and the recent Fed move were the signposts that we have entered this stage). Mature stage investment cycles are typified by volatility shocks that are both more frequent and increasing in amplitude. August / September 2015 was the first seismic shock. It appears January 2016 is lining up to be a quite a nasty aftershock. The bad news is that we should expect more of them.
What’s the wash-up for the portfolio?
Well, this is where our defensive players have a chance to shine. Constructing a portfolio is a little like putting together a well-balanced football team – you need a good mix of both attack and defence. Attack is needed to take advantage of opportunities when things are going your way. Defence is needed to preserve your gains when things are going against you. As is the case with all coaching jobs there is always fine-tuning to be done and we looked upon the August / September 2015 volatility shock as a good test run for our defensive line up. We made some subtle changes in response – even though our defensives did very well in preserving capital over the downturn (our losses were less than a quarter of those experienced by the ASX 200). Given this, we feel our defensive line up should place us in good stead for January 2016.
So where could we go wrong?
As always, one must approach such market upheavals with a significant degree of humility. ‘Forecasting risk’ (as it is known) is an age old bugbear of the investment profession. Even though our base case scenario is that the present downturn is just one of the many bumps along the road to be experienced before the next ‘big one’ goes off we could be always wrong.
So how would the portfolio cope should financial markets rapidly slide into a bear market abyss from here?
Well, again, to some extent we have an array of defensive players in place whose aim is to make money even in bear markets. No doubt if the present shock is the start of another GFC type event we would also make asset allocation changes to bring even more resources away from ‘attack’ toward ‘defence’ – but our ‘sleep at night’ insurance is that we already have some of these defensive positions in place.
So what are the signposts to look for that the present market shakeout is something more sinister than a mere (albeit significant) market retraction?
In short, any sort of banking / financial sector balance sheet carnage. The banking / financial sector represents the vital organs of the global economy. If these are in any way significantly impinged by present events then we could be in for trouble. The market’s present problems started with balance sheet issues (namely in China’s property / provincial government sector) and the implications that this has had for the rebalancing of China’s economy. If in any way it seems that this balance sheet problem is flowing into China’s wholesale banking sector (and they don’t have the governmental resources to ‘mop up it up’), or even worse, the present balance sheet problem somehow escapes out of China and into the global financial sector then all bets are off. If this is the case then even though the US economy is showing resounding signs of strength and things are starting to improve in Europe, it would prove dire for the global economy. We hope this is not the case and that we are experiencing a mere mature cycle volatility shock but the good news is that even if this is not the case, the portfolio already has defensive players in place to limit the downside should the worst occur.
How is the Stonehouse Investment Committee handing this Volatility?
We understand some investors find such periods of market instability and severe short term weakness disheartening or even frightening. However, we need to stay focused on these volatile short term market moves because such periods often produce the most compelling longer term opportunities and it is important investors don’t become overly focused on short term movements. Instead, the aim should be to keep an eye on longer term return targets and investment goals.