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The real shock in global markets in 2016

Shock is a matter of perspective and expectation. Imagine a time traveller stepped through the door a year ago and said the UK would vote to leave the European Union, a presidential candidate who advocated debt renegotiation would be headed for the White House, and Italy would reject the reforms of Prime Minister Matteo Renzi.

Who would have predicted a worldwide bull market for stocks and bonds? And yet, weighted by size and measured in local currency, the average stock market is worth a tenth more today than it was at the start of January.

“Had I, or anyone else, sat down and forecast today’s levels and events, someone would have put a straitjacket around me,” says David Lloyd, head of institutional public debt for M&G investment management.

A big part of the reason is what happened at the start of the year. The Federal Reserve had just raised interest rates for the first time in almost a decade, and more increases were expected.

The first shock changed all that. “The big sell-off of the year was actually around China, in January, not Brexit or Trump. It was meaningful because it destroyed the consensus for four Fed hikes in 2016 and caused a big sell-off in the dollar,” says Trevor Greetham, head of multi asset for Royal London.

The value of the US currency had been rising, depressing prices for commodities denominated in dollars. Life was also expected to be hard for emerging market economies with big raw materials industries.

But measures taken by the Chinese authorities to calm domestic stock markets in the first days of January backfired, sparking worldwide financial turmoil. The price of oil dropped to its lowest level in 13 years.

So, in the same way market mayhem had delayed movement in US interest rates the previous September, traders and investors eventually reached a more sanguine conclusion. “In each case the market concluded it meant more not less stimulus,” says Mr Greetham.

The effect on bond prices was dramatic, illustrated at the extreme by the change in value for an index linked gilt maturing in 2068.

“When you think it started off the year with a negative real yield of 0.8 per cent, the result is astounding,” says Mr Lloyd. At that price it looked like a terrible deal: a buyer was accepting an investment which would deliver an income 0.8 percentage points below the annual rate of UK inflation for half a century, a guaranteed erosion of value.

It might have been taken as a sign of the desperate paucity of long-term investments available. Yet in the months which followed, central banks around the world took measures to suppress borrowing costs, pushing up the value of bonds.

Japan announced a surprise experiment with interest rates below zero. The European Central Bank turned to new measures, such as buying corporate debt. The Bank of England cut interest rates following the UK referendum, as fears for the long-term economic fallout prompted a rush for safe government debt.

By October the real yield on the 2068 linker had dropped to minus 1.95 per cent, producing a gain to its owners of almost 68 per cent. Even with a reversal in recent months, the bond is still worth about 50 per cent more than it was a year ago.

So for UK investors the shock might be just how well their investments have performed. Thanks to the collapse in sterling, which has boosted the value of foreign assets and the value of foreign profits to many UK listed companies, a typical diversified UK investor is 10 per cent to 20 per cent richer this year, says Mr Greetham.

The story of the year can also be seen in prices for bonds issued by the riskiest companies. Lending to those businesses with too much debt, or in too fragile a shape to warrant an investment grade assessment from the credit rating companies, would be dangerous if an economic slowdown was in prospect.

Yet high yield debt of European non-financial companies has produced an investment return of almost 10 per cent this year. For the US equivalent, the gain is 16 per cent.

“The reaction in the bond and loan market to Brexit lasted about three weeks,” says Martin Horne, head of European high yield for Barings. “Trump was about an hour.”

A big part of the strong markets are economies where growth and employment statistics are improving. Moody’s Investors Service, for instance, predicts recession in only two countries across the whole of Europe, the Middle East and Africa next year: Belarus and Syria.

One region not joining in, however, is Europe. The broad Euro Stoxx index has dropped almost 4 per cent, in part on fears for what politics holds in store for 2017.

“Investors have stayed out of Europe because of the elections in France, in the Netherlands, and later in Germany,” says Hartwig Kos, an investor for SYZ Asset Management who expects Angela Merkel to remain chancellor, but with a weaker coalition.

“If you have a rightwing party all of a sudden polling in Germany at 20 per cent, markets will be concerned,” he says.

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