It has been a confusing start to 2016 for many investors but on many measures, the economic outlook does not appear alarming.
Economic growth appears to have exceeded initial 2015 forecasts in Europe and the UK, while Japan is also showing signs of picking up. These countries are still biased towards accommodative monetary policy that should offer ongoing economic support.
Developed market consumer spending remains resilient. US job growth remains exceptionally strong and services sectors, which account for the majority of the economy, are expanding. Moreover, the renewed weakness in oil should act as a further stimulus to consumption.
Despite these seemingly positive economic fundamentals, global equity markets fell sharply over the first 20 days of January. The MSCI UK index fell by more than 9 per cent and high yield credit spreads widened substantially.
Performance of index over 2016
Source: FE Analytics
A challenging liquidity environment explains why markets are falling despite reasonably resilient economic fundamentals.
Since the financial crisis, quantitative easing policies have created cheap money that has supported global financial markets, in part by financing strong credit creation in emerging markets. However, the virtual cycle of liquidity has now reversed due to the strong US dollar, higher US interest rates, and debt and overcapacity problems in China and commodity markets.
These issues are feeding off each other and have created a self-reinforcing downward spiral in asset prices that is proving difficult to break. There is a real risk that this erodes the fundamental outlook and drags the US and/or global economy into recession.
We are looking for evidence that the US and Chinese authorities understand and are willing to reverse their policy errors to trigger a sustainable improvement of liquidity conditions. It is difficult to predict the timing of their policy announcements but ultimately, we believe that the economic environment is unable to support higher interest rates and can only generate modest growth.
This is likely to enable government bonds to confound the negative consensus and enjoy a strong year in 2016. Gilt funds and higher-duration strategic bond funds remain important and relevant tools in portfolio construction.
Performance of sectors over 3yrs
Source: FE Analytics
Elsewhere, we believe it is probable that higher-risk assets such as equities will continue to struggle before the global liquidity issues move closer to resolution.
However, high yield bonds have been particularly weak over a prolonged period of more than 18 months. Even outside the stressed energy sector, they appear cheap for any outcome other than a recession. With economic fundamentals still robust, this may be an attractive entry point into the market, especially as 2011 showed that high yield can overreact to deteriorating liquidity.
We are gradually adding to beneficiaries of a recovery in the sector. Kames High Yield Bond is a long-term holding and we are also identifying closed-ended fund opportunities.
Turning to another higher-risk bond market, we are not yet ready to purchase emerging market credit funds.
Performance of sectors over 3yrs
Source: FE Analytics
The asset class has been resilient so far but we expect many emerging markets to face their own debt crisis that will significantly undermine the corporate bond market. Emerging market equities have been much weaker and are much closer to attractive long-term entry levels but would still suffer if crisis conditions intensify.
Although it has been a challenging start to the year, the weakness in most markets has not been fully related to fundamentals. This means that opportunities are emerging to buy assets at levels that may offer long-term value. It is also creating more market anomalies to exploit, for example the extent of high yield relative to emerging market credit and even equities.
Mark Harris is head of multi-asset at City Financial. The views expressed above are his own and should not be taken as investment advice.
