Volatility has persisted in the equity markets in the first quarter. Following a steep drop early in the year, markets recovered their poise somewhat with the UK and US markets recouping their losses. European and Asian markets fared less well, closing the quarter with declines across the board.
The recovery in equity markets appears counterintuitive given the outlook for weaker global growth. In our view, it has been driven by two main factors. Firstly, a bounce in oil and commodities has helped improve sentiment. The energy and basic materials sectors have been obvious beneficiaries along with certain emerging markets. The rebound in oil, however, has largely been caused by investors closing out of short positions and will not be sustainable in the long run if fundamentals do not improve.
Secondly, there has been further central bank intervention in the form of lower interest rates and easier monetary policy in particular from Europe and Japan. Expectations of higher rates in the US have been set back too. Given the strength in the euro and yen, both the ECB and the Bank of Japan are likely to be emboldened to do more in an attempt to weaken their currencies and secure growth by boosting their exports. The strategy is not certain to work in the long term, especially in a world of competitive devaluation where many countries are pursuing similar strategies. Lower interest rates have forced investors to take risks to maintain income but this has put capital preservation at peril.
If there is insufficient demand, there is a limit as to how much credit can be created even with negative rates. In any case, the incremental gain from credit creation is diminishing. In China, for example, credit growth has risen to 14.7% on the year but the actual level of GDP growth has clearly deteriorated, falling below 7%. A recent influential survey showed that the business climate has weakened. The first quarter saw only a third of companies growing capital expenditure, the lowest proportion in five years, with hiring falling to a four year low. In reflection, Chinese equities have declined sharply, down over 40% from the highs in 2015, suggesting that markets had priced in overly optimistic prospects. Following this correction, emerging markets look more favourable, with a lower growth profile now factored into the near term valuation.
With interest rates expected to be lower for longer, creating less of an incentive to hold cash, the case for gold, as an alternative currency, has been strengthened. Gold has performed well in the first quarter, after we highlighted the case for investment in January, and remains an important diversifier in portfolios. A selective approach to stock selection is warranted, with a focus on value crucial.