Asset Allocator: August 2015- Assessing the fallout

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

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ASSET ALLOCATOR: August 2015 

25/08/15- Assessing the Fallout 

 

What a difference a few days make! I’ve been fairly pessimistic about prospects for risky assets like equities for much of the summer but even I didn’t expect quite the blow out we’ve seen over the last few days. Back in the early summer for instance I suspected that the equity markets had got too far ahead of themselves, and that a combination of Greece’s travails and the price of oil might trip up the markets. At that time within my own portfolio I opened a bearish, short position using an SG Infinite Turbo, ticker MF04. If my memory serves me properly, the FTSE 100 at the time of purchase was in its 6700 to 6900 trading range and my own guesstimate was that this benchmark index might fall to 6300 by the end of the summer. The pause in the Greek drama caused me to sell the turbo as the FTSE hit around 6500 but I never for one moment expected the FTSE 100 to slip below 6000.  Now that this has happened I think investors do need to think their way through two inter related decisions. 

The first is whether we’re in for a really momentous sell off that would make the falls of 2011 look rather pedestrian? My own sense is that we’re not quite there yet though every day of big, dramatic falls does begin to raise the prospect of a brutish rout and the start of a major bear market. I’ll explore this theme of market risk below. 

Next up if one assumes that we aren’t entering into a financial meltdown – still my default though admittedly optimistic scenario – then we need to consider when we should consider re-entering key asset classes. 

One could apply all sorts of valuation metrics to this analysis but for simplicity’s sake I’m operating under four basic assumptions within my own portfolio:  

  •      The FTSE 100 looks cheap at any point under 5800
  •      The S&P 500 has much more to lose as valuations were already looking excessive. My position would be too buy if it falls below 1750.
  •      Chinese equities were vastly over valued and probably need another fall of 20% before we've seen a proper 40 to 50% peak to trough correction
  •      Oil prices are heading much lower. A few weeks back I slightly optimistically thought we might see a brief rally in oil prices before a long relentless decline towards $20 a barrel but I’ve now changed my mind. Its straight           down from here on in! Our next target is for oil to hit $30 a barrel for oil out of Cushing and a low of $30 for Brent in the next four months. 

If one operates under these assumptions, I’d suggest we’re not far off a re-entry point for many asset classes. The catalysts for a major move upwards will be contained in mixed messages coming out of China – the markets have convinced themselves that China is sliding fast and they’ll need to be reassured by the monetary authorities that we’re not about to see a recession in the world’s second largest economy. 

My cautious optimism is also fuelled by the fact that the key measure of volatility has spiked enormously in recent days. In fact last week saw the biggest weekly rise ever in VIX volatility of 118%. The chart below sets out this remarkable story - the VIX index climbed 46.45% on Friday and is also up 104% in just a month. I’d argue that this spike is massively over bought given how restrained the markets have been in the past four years but there is also a worrying dimension to this spike. This jump could trigger many short stops, with the possibility that the VIX index could move even higher – especially as the VIX market has been dominated by premium sellers who’ve assumed that the VIX would stay low for the near future.

Chart – The VIX index over the last 26 weeks – source www.sharepad.co.uk

 


But maybe the markets in volatility are telling us a very different story - that the global economy is one ste

p away from outright recession and that the current market mayhem may intensify?   

At this stage I think it’s worth dwelling on the recent research produced by risk consultants at Check Risk. This Bath based firm spends all its time analysing market attributes and has an excellent record in calling market corrections. Its analysts are most concerned by what’s called a ‘compression event’ – in other words, a seriously turbulent market where “the long term becomes much closer to the present as if it is being telescoped. Events that should not take place until two years out are triggered in the present.” 

This fear of a compression event comprised of a disparate number of factors could spark a massive decline in equity markets. What factors are worth watching out for? I’d suggest the following order of events: 

  1.    The Chinese slowdown is a harbinger of a Chinese recession
  2.    Currency wars escalate
  3.    Oil prices move towards $30 and then $20 a barrel
  4.    Leverage becomes a real fear in the US equity markets as investor start to worry about the binge in debt by major corporates in recent years
  5.    Greek elections in September
  6.    Bond market volatility rises and some sovereigns start selling US TYreasuries
  7.    Markets begin to worry that continued low rates and QE aren’t having the impact they’re supposed to have
  8.    The US economy slows sharply as we head into the winter, helped along by bad weather and a strong dollar  

This chain of events could spark a real crisis focused on debt levels and leverage again. Investors could decide that they don’t like the look of QE4 and the new normal and sell off all assets in a singular, super correlated event.  My own take is that the analysts at Check Risk have got it right when they suggest one of three scenarios below: 

  1.  “The US Federal Reserve is unable to raise rates in September or December and forced into QE4. QE4 may seem like madness right now. If the stock market correction spills over into bond market volatility, or worse still, the selling of US Treasuries by EM’s then it is entirely possible. No matter that, the monetary policy gun is fast running out of ammunition. If QE4, or the rumour of more accommodative action were to circulate then we will have been looking at a nasty correction from June until August but nothing more. Markets will recover quickly.
  2.  If the central banks have decided just to stand by and watch, something we very much doubt, then the possibility of a full-blown crash is much more likely. For this to happen the Chinese would have to stop intervening in the stock market and sell US bonds aggressively. … The Chinese economy is growing much slower than forecast, and the Chinese have the money to pump prime their economy. They will do so.
  3.  A thermal runaway is a description of what happens to certain types of battery circuits when they get too hot. Effectively the heat gets to a tipping point where it becomes difficult to control more heat being generated and the battery either catches fire or explodes. There is a similar risk effect in stock markets. ….Risk usually dissipates when the risk is known. However, in some non-benign risk environments risk clusters. Risk, in effect, generates more risk. To be clear, we are not at this stage yet, however, the possibility of a risk cluster forming exists. The downside pressure on markets is almost without resistance at present.” 

 

If I had to bet on an outcome over the next few months I’d suggest that we’ll see a flurry of policy activity in September and October and a strong rebound in the markets from mid-November onwards. Sadly until we get there we’ve got at many more nasty and volatile weeks ahead of us – we’re not at the bottom just yet!

But on a more tactical note I’d conclude by agreeing with a note this week from BlackRocks global investment strategist Russ Koesterich when he suggest that the selling is probably already over done in the Eurozone. He reminds us that in local currency terms European and German stocks are now down 15% and 18%, respectively, helping to push valuations to recent lows. Koesterich observes that “German equities are now trading at less than 12 times forward earnings and 1.5 times book value, roughly a 45% discount to the United States. While European growth is likely to remain lower than in the U.S., given the size of the discount and the fact that the major risk associated with Greece has been temporarily removed, the current discount suggests European equities once again look attractive.”   

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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