Where next for the global economy?
The painful shake-out in global equities after China's decision to devalue its currency in early August has left our team of five asset allocation panellists much divided in their opinions.
They seem to agree on just two things: the property sector is still the most favoured sector; and US equities are fully valued. Any wider sense of them singing from the same hymn sheet appears to have ended.
Our most optimistic member - Alan Higgins of Coutts - is forthright: 'I think equities can do really well from here,' he says. In particular, he feels the anxiety over China has been much overdone. 'The old investment adage says that when the US sneezes, the world catches cold. We don't think that is the case for China.'
Since the global financial crisis, he argues, China has been seen as the global growth champion. 'Now it is looking under the weather, and investors are getting fearful for the health of the rest of the world,' he says. 'We think this is a case of hypochondria.'
MAJOR CORRECTION HAS BEEN EXPECTED
It is fair to say that most fund managers have been half-expecting a major correction in equities for some time. After all, since the low point in early 2009 all the major indices in the developed markets - the US, the UK, Europe and Japan - had more or less trebled by the spring of 2015.
Indeed, the US's Nasdaq 100 index of technology stocks quadrupled during that time. Higgins says: 'Everyone was looking for a correction - and the markets found reasons to have one in the way the Chinese have been behaving.'
However, he refuses to pander to market neurosis and remains convinced that the developed world can withstand a slowdown or even a recession in China - essentially because the resultant weakness of commodity and energy prices will put more spending power into the pockets of consumers.
His latest scores reflect his optimism. He has boosted his score from 6 to 8 for UK equities, European equities and Japanese equities. He has even upgraded his US equities score from 4 to 5. And to underline this positive approach on equities, he is leaving his scores for cash (2) and government bonds (3) unchanged.
'We think value has re-emerged in equities,' he says. 'So we are putting more money into them. For example Coutts' balanced fund went from being 10 per cent overweight in equities at the beginning of the year down to 6 per cent in the summer. We are now taking it up to 8 per cent.'
Schroders' Keith Wade may broadly agree with Higgins that China's slowdown is not going to derail the world economy. But he is not adopting the same bullish line on equities.
Wade agrees he was surprised by the markets' reaction to Chinese devaluation. 'We have never forecast a hard landing in China - and we are still not forecasting one,' he says. 'We take the view that the authorities there can still pull some levers.
'But what worries us is the rather clumsy way they have been pulling those levers - first in the way they devalued the yuan and secondly in the way they intervened in equity markets. We are left with the feeling that they are not as competent as we thought they were.'
Overall, Wade comes out with a much more cautious scoring approach to markets, and generally speaking he is moving in the opposite direction to Alan Higgins.
To lower risk levels, he is seeking less cyclical investments. The result is a lowering of his European equities score from 7 to 6, while his Japanese score is down from 7 to 4.
Wade leaves his UK score unchanged, but raises his US score, reflecting the growing belief that the US economy will be least affected of all by the Chinese slowdown.
This increase in caution also persuades him to raise his UK and global bond scores from 4 to 5 while pushing his corporate bond score from 4 to 6.
At Aberdeen Asset Managers, Richard Dunbar acknowledges they 'took a lot of money out of equities' when the Bank of China changed policy and went for a devaluation. 'We took some equity risk off the table just to see how markets developed in September,' he says. 'We are sitting on our hands wondering whether or not to buy back that exposure.'
He feels the Chinese decision to devalue was understandable. 'They are an export-led economy and they had seen both the Japanese and the Europeans devalue their currencies against the dollar by one third,' he says. 'The pressures on the Chinese to do something had intensified.'
Dunbar believes there is a great division of opinion over where financial markets are heading next. 'Some say everything is going to be OK and equities are 10 per cent or so cheaper than they were at the beginning of the summer. But others are saying something significant has changed and it is time to look again at risk assets.'
He himself verges towards caution in his scoring. Down a notch go his scores for both emerging markets equities and Japanese equities. More significantly, he has edged up his government bond scores from 1 to 3.
'I would characterise our thinking as being very slightly overweight in risk assets such as equities and real estate, and slightly underweight in bonds,' Dunbar says. 'It is not a portfolio that is heading for the bunkers.'
Rob Burdett at F&C Investments is another panellist pushing his score on UK and global government bonds from 4 to 5, while raising his cash score to a 6. His mood too remains cautious.
Looking at equities, he says: 'Longer term, we want to go overweight in equities again, but at the moment we are neutral. Valuations now suggest we should be buying into the dip in markets, but there are some things about the situation we do not like. We think a major fall like this requires more analysis, as some of the worries could become self-fulfilling.'
He believes the decision of the US Federal Reserve to postpone a rise in interest rates reflects fears of deflation. 'It is vital that the world economy continues to grow,' Burdett argues. 'If it doesn't, we will get deflation.'
Schroders' Keith Wade echoes those concerns: 'It really is quite difficult for the authorities like the Fed to deal with slow growth in the global economy when we have had a huge amount of monetary stimulus already, interest rates are close to zero and fiscal policy is constrained,' he points out. He is now forecasting the Fed will not raise interest rates until next March.
Burdett, however, remains hopeful that deflation will be avoided, given that the global economy is still growing; inflation might be boosted as the effect of last year's sharp drop in the oil price is no longer being reflected in the inflation statistics. He also sees strong signs of real wage growth.
He nevertheless leaves his scores for UK equities and for Japanese equities unchanged. He raises his US equities score from 4 to 5 but lowers his score for European equities, noting that Europeans, particularly the Germans, are heavy exporters to China.
STAY IN NEUTRAL
Burdett keeps neutral on emerging markets: he describes the sector as 'fantastically cheap' on valuations, but fears these markets remain vulnerable to competitive devaluations.
Chris Wyllie at Connor Broadley has been what he calls 'maximum underweight' in equities since May. 'Our balanced fund would in normal conditions be about 70 per cent in equities. Since May we have been down to 55 per cent,' he says. 'That is the bottom of our normal band. But of course if we thought we were in a bear market we would go lower than that.'
At this point Wyllie is not that bearish. 'I don't think a global downturn is a negligible risk, but on the other hand valuations for equities are looking attractive. For example, the yield on UK equities against the 10-year UK government bond yield has risen to 2 per cent. In the past that has been a very reliable buy signal.'
However, he clearly remains cautious, and he keeps his UK equities score for the present at 5. He also retains an underweight score of 3 for the US, claiming there are some pockets of 'gross overvaluation' in US equities.
Moreover, he is lowering his score on Japanese equities from 7 to 5. Here, his concern focuses on the ability of the Japanese to cope with the climate of competitive devaluations in the Asian region. 'They can no longer keep devaluing the yen,' he says. 'Profit margins may come under pressure.'
On Europe he remains hopeful of continuing growth and maintains a score of 7. He reiterates his view that it is now far too late to sell emerging markets. So his score there also remains unchanged. 'There remains quite a strong valuation case, and selling of emerging market stocks has recently abated,' he claims. 'Is there anyone left to sell?'
None of the panellists has altered a score for the commodities sector, which remains very much in the doldrums. Any sign of an upturn in base metal and oil prices would be seen as a very encouraging sign that the growth in the global economy is quickening, rather than slowing as the recent scares over China and unchanged US interest rates have been suggesting.
Again, Higgins at Coutts provides a hopeful straw in the wind. There is evidence of what he calls 'a long-run mean reversion in commodities'. By this he means there is statistical evidence to show that when commodity prices are really high over a five- or six-year period, then we should expect them to fall. Conversely, when commodity prices have been weak over a five- or six-year period - as is now the case - that is a time to expect them to rise.
'That is part of the evidence building that commodities are oversold,' Higgins says. 'But as yet that is not something we are ready to take action on in our investments.'
PROSPERITY FOR PROPERTY MARKETS
In a volatile financial world, one area of stability - for the moment at least - seems to be the commercial property market. All our panellists, apart from the more cautious Burdett, continue to favour the sector. Indeed all the scores they have recorded remain unchanged.
Higgins continues with his score from August of 9. 'I am proud of that decision. We were basking in post-election euphoria, but it has worked out well,' he says.
Like Wyllie, Wade and Dunbar, Higgins continues to favour the sector, 'on the grounds that the UK economy is going well and the sector offers a decent yield; and in stark contrast to equities at the moment, it has the added attraction of low volatility.'
Higgins admits that when a sector performs well after he has given it a high score, it would be normal to downgrade the score. 'But I have decided to keep it at this level for another three months. If we have another strong quarter in property, I think I will downgrade after that.'
The property specialists whom Wyllie talks to report what he calls 'an improvement in tenant behaviour'. By that, they apparently mean that their corporate clients are proving ready to move into new head offices or to upgrade their office accommodation as confidence in Britain's economic prospects continues to increase.
Meanwhile, in both the Schroders and the Aberdeen Asset Management camps, the support for property as the current highest rated sector persists.
According to Wyllie there are some concerns about the wall of foreign investment money hitting the sector, and fears about how quickly that might unravel if sentiment changes. But these worries do not as yet appear to have surfaced against the current background of Britain's hopeful economic background and the apparent prospect of political stability.