The FTSE SmallCap and Aim indices, the hunting ground for my small-cap stock picks, have fared much better in the circumstances, posting peak-to-trough falls of 8 per cent since hitting their bull market highs in early June. That’s no reason to be complacent at all. Indeed, it’s important to ascertain whether the factors driving the recent decline are deep rooted enough for a ‘mere’ correction to turn into one of the stock market routs that have punctuated my career in financial markets over the past 25 years.
It’s my view that the latest equity market storm, though initially sparked by likely impact of monetary policy tightening later this year by the US central bank, is largely being driven by growth concerns and earnings downgrades in Asian Pacific markets, and the fallout from the ongoing slowdown in the Chinese economy, and the lack of credible response from its government. This explains why we have not seen the same volatility in UK and European small-caps as their large-cap counterparts recently because their businesses are more domestically focused and more insulated from slowing growth in Asia. But clearly there is a problem in Asia and one that the second-quarter earnings season highlighted.
For instance, in the three month period, a net 9 per cent of companies in the MSCI Asian Pacific ex-Japan index missed EPS consensus estimates. Revenues were even worse. As strategist Niall MacLeod at investment bank UBS rightly points out this reflects three key factors: lower commodity prices, while supportive for margins, have been a drag on top-line growth especially in commodity sensitive sectors and countries; domestic demand has been soft – purchasing manager indices (PMIs) in the Asia Pacific region remain relatively weak and year-on-year revenue growth has turned negative for industrials and utilities; and thirdly, exports have been subdued, especially into Europe as the depreciation of the euro takes its toll.
In turn, EPS downgrades have accelerated: since the start of June the consensus bottom-up EPS growth forecast for 2015 has fallen from 10.9 per cent to 6.2 per cent. An additional issue for the regional index is that it is denominated in US dollars so underlying earnings face a translational impact from Asian currency weakness against the greenback. In fact, UBS still see downside risk to their Asia ex-Japan EPS forecast from weaker than anticipated top-line growth and the currency impact.
To compound matters, the unexpected devaluation of the Chinese renminbi has stoked fears that the country’s economic slowdown – the latest data showed that China’s manufacturing sector is shrinking at its fastest pace since 2009 – could be far worse than feared. It also raises the risk of a chain of competitive devaluations emerging too if regional central banks act to try to regain their lost competitiveness against China. And of course a deflating stock market bubble in Shanghai is accentuating growth concerns: the Shanghai Shenzhen Composite Index has fallen 35 per cent in the past 11 weeks. The negative wealth effect aside, the sharp falls in equity prices will hinder the ability of companies to tap financial markets and refinance overleveraged balance sheets. Mirroring these global growth fears is a deflating oil price which has slumped to its lowest level since the March 2009 bear market low, having fallen by a third since the end of June.
The jittery market environment has not been helped either by the resignation of Greek Prime Minister Alexis Tsipras last week when he called a snap general election to ask the Greek people to pass judgment on the country's €86bn (£63bn) bailout deal.
A sense of perspective
Despite this gloomy backdrop, I think some perspective is required. Firstly, the chances of the US Federal Reserve increasing interest rates at next month’s meeting of the Federal Open Market Committee (FOMC) have decreased markedly as a result of the chain of events in recent weeks. Futures markets are now pricing in only a one-in three chance of a rate hike compared to a 50 per cent chance only a few weeks ago.
Frankly, I would go one step further and state that there is no chance whatsoever of the FOMC tightening monetary policy and removing liquidity from markets in three weeks time if it risks setting off another deflationary downward spiral in asset prices, hinders global growth expectations and undermines the US economy. Having waited so long to tighten rates, doing so now in the midst of a severe equity market correction would not only be irresponsible, but ultimately self defeating. If I am right, then this should give Asian markets some much needed respite, and much needed stability.
Secondly, as Anna Haugaard of Brewin Dolphin points out, the “deflationary impulse coming from China will now allow the European Central Bank to extend or expand its quantitative easing (QE) programme”. That’s because Europe saw its equity market rally lose traction earlier this year as inflation expectations and indicators signalled an early withdrawal of QE. However, with the commodity complex at multiyear lows, this raises the possibility of further money printing by the ECB in an attempt to maintain the reflation of the region’s economy and to counter the deflationary impact of lower oil and commodity prices. It’s also worth pointing out that Europe is a large net oil importer so the latest dip in oil prices not only lowers costs for businesses, but adds to consumers’ spending power. The twin effects of a delayed interest rate rise in the US, and potential for more QE in Europe, is a net positive for equities.
Thirdly, having fallen by over 23 per cent since peaking out, valuations in the Asia Pacific region are close to levels associated with previous recession trough lows (1.3 times price-to-book value ratio on MSCI Asia ex Japan index), but are admittedly still well above the very depressed levels which marked the low points in the two most recent crises (1998 Asian crisis and 2008 financial crisis) when valuations troughed at around 1.1 times book value. In terms of forward PE ratios, the rating of the Asia Pacific region is now within 10 per cent of prior market troughs which have coincided with corrections during previous Federal Reserve tightening. The current multiple is around 10.5 times prospective earnings following the rout on Monday 24 August.
Clearly, with global markets under severe pressure, it takes nerves of steel to contemplate buying equities right now especially if the Asian growth scare morphs into a crisis like 1998. The implication from my assessment of past market bottoms is that equities in Asian markets could potentially fall another 10 per cent, and western equities would be dragged down further with them. Although valuations are the main driver of long-term returns, the key driver over shorter horizons is the attitude of investors toward risk, and at the moment they are running scared.
Capitulation coming
But in the coming weeks I think we could see markets enter their capitulation stage as investors throw in the towel. It should provide us with a great opportunity for buying shares in heavily oversold quality companies.
We are certainly getting there as the Wall Street gauge of fear, the VIX index, spiked by 118 per cent to above 28 last week, with 2.3m bearish options traded on Friday alone, an all-time record. Since 1990, the VIX has only doubled once before in a three day trading period as it did last week – in August 2011 – and one month later the blue-chip S&P 500 was up almost 6 per cent, and within three months was 12 per cent ahead. It was a sign of the beginning of the end game.
And this is not the only indicator of bearish sentiment. The well respected AAII Individual Investor poll in the USA has had more bears than bulls for four straight weeks, and less than 27 per cent of participants are now in the bull camp, down from 58 per cent earlier this year. Fear is all consuming, but it is now getting into extreme territory, another sign of the market entering the washout period. It’s worth noting too that the Bank of America Merrill Lynch August survey of fund managers revealed that they had built up their cash levels to 5.2 per cent of assets, just below the post-2008 peak of 5.5 per cent. So, importantly asset managers have the funds available to buy into the market rout when it bottoms.
I am sure they will because with the S&P 500 trading on 16.2 times fiscal 2015 operating earnings estimates, this means that the earnings yield of 6.2 per cent on the index is more than three times the 1.97 per cent yield on 10-year U.S. government bonds. The dividend yield on the index is marginally above the bond yield too. That may not be a bargain, but if the Federal Reserve puts its rate hiking plans on hold as looks increasingly likely for the reasons I have given above, and with the upside from lower energy prices set to give the US economy a boost, undoubtedly that rating will look like an attractive entry point to many fund managers wishing to ride the US economic recovery.
It’s also fair to say that the Bank of England’s plans to raise bank base rate could be pushed back yet again given the deflationary impact of cheaper Asian imports and lower energy costs, underpinning the attraction of sectors with exposure to the strong domestic economic recovery.
But of course to arrest the decline and bring the buyers back we need a catalyst, the most obvious of which will be a flood of new liquidity from the Chinese authorities. It’s a distinct possibility in my view. The rhetoric emerging from the Federal Reserve’s FOMC meeting in a few weeks time will be closely watched too. I will also be keeping a close eye on credit spreads in the bond markets as they have proved to be a great indicator of improving investor sentiment. More often than not the credit markets signpost an end to the downtrend well before equity markets do.
The bottom line is that I feel that this will ultimately prove to be a growth scare-driven market correction worth taking advantage of. In the circumstances, I plan to continue to seek out undervalued UK small-cap value plays as I have been doing so all year in order to take advantage of some of the attractive medium-term buying opportunities that are now emerging.
Please note that my next column will appear online at 12pm on Thursday, 27 August.
MORE FROM SIMON THOMPSON...
I have published articles on the following companies last week:
■ Inspired Capital: Accept cash offer of 21.5p; Record: Buy at 40p; Pittards: Buy at 128p; Netplay TV: Buy at 9.5p ('Bargain shares updates', 17 August 2015)
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
