Volatility to Stay as Investors Face New Realities | American Funds

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Investment Insights

January 2016

Volatile Markets to Persist as Investors Adjust to New Realities

  • High levels of volatility expected to continue as markets adjust to slowing growth in China, lower oil prices and weak industrial activity.
  • While stock prices could fluctuate further, chances of a global recession or a financial crisis are low.
  • Modest expansion in developed economies will partly offset deceleration in China.
  • Equity valuations in Europe are attractive and leave room for potential gains.
  • M&A activity is supportive and there remain many areas of opportunity in financial markets.

With global stocks declining sharply in the first two weeks of the year, 2016 has immediately presented a challenging environment for investors. Worries about slowing economic growth in China and falling oil prices have driven stock prices lower, while safe-haven assets such as gold and Treasury bonds have rallied. Investors should expect volatility to remain elevated while markets adjust to the realities of persistently low commodity prices and a wrenching deceleration in China — formerly a strong engine of global economic growth.

“When a nation like China goes from 10% GDP growth just a few years ago to what, by some estimates, could be as low as 3% today, that is painful,” said Capital Group chairman and portfolio manager Tim Armour. “That brings with it a difficult period of adjustment, not just for China but for the entire world. It’s the biggest wild card in the markets right now and there is a great deal of uncertainty as to how it will play out.”

“That said, I think we will get through this rough patch and likely end up with a reasonably good year in the markets,” Armour added. “Keep in mind, the U.S. economy is continuing to grow at a moderate pace. Europe’s economy is improving and, in my view, equity valuations there look attractive. If you put that together with an eventual stabilization in China, I think you wind up with a decent market environment and plenty of compelling investment opportunities going forward.”

While stocks have started the year off poorly, many portfolio managers do not see it as a brewing financial crisis, but rather a market correction fueled in part by full valuations in many sectors.

“This isn’t a repeat of 2007 with margin calls, liquidity pull back, a deep recession or anything like that. Equity valuations are correcting for good reasons,” said portfolio manager Rob Neithart. 

At the center of market concerns have been China’s attempts to transition to more sustainable growth and the challenge of servicing a large amount of debt in this slow-growth environment. The government has attempted to bring down interest rates, partly by devaluing its currency. But that, in turn, has led to capital flight, with China residents taking money abroad. That has complicated the government’s efforts, shaken investor confidence and triggered a sharp decline in Chinese equities.

“If this was the beginning of a prolonged debt crisis in China, I would be a lot more worried, but I don’t think that is the case,” Neithart added. “Chinese authorities have a degree of control over the financial system, and the government will likely stretch out these adjustments over five to 10 years, just as we saw in Japan. It may be bad for their stock market, but I do not see it developing into a global macroeconomic crisis.” 

Adding to investor worries has been China’s decision to repeatedly allow its currency, the renminbi, to lose value in relation to the U.S. dollar.

“The devaluation of the renminbi in early January caused a great deal of market disruption,” said portfolio manager Mark Brett. “However, the Chinese authorities’ approach shouldn’t be any surprise: this is the fourth devaluation in the last couple of years. Once the renminbi slips a few percent, they intervene to put the brakes on. The renminbi appears overvalued by roughly 10% to 15%, in my view, but I don’t think ’competitive devaluation’ is the real goal here. Rather, authorities seem to be easing monetary conditions to address the large amount of debt that has built up in the Chinese economy over recent years.”

How do these unfolding events in China affect the outlook for U.S. stocks? Even though China is not considered a major export market for U.S. companies, the forces of globalization have intertwined economies like never before.

“It’s hard to argue that there is no impact,” said portfolio manager Jody Jonsson. “Everywhere you turn, U.S. companies have exposure to China. It’s difficult to be an industrial company and not sell to China. Whether it’s aircraft engines, power equipment or mining and construction equipment, China has accounted for the bulk of growth in industrial demand for many years, and that demand is now rapidly in decline,” leading to a worldwide slowdown in industrial activity. 

However, “we are likely closer to the end than the beginning of this slowdown in the industrial cycle,” Neithart added. The sharp decline in oil, down more than 70% from its peak and hovering around $30 a barrel, is a negative factor for oil companies and some areas of the economy, but a positive factor for industrial companies and consumers.

While the U.S. economy as a whole is not overly dependent on exports or manufacturing activity, the largest U.S. companies — particularly those in the S&P 500 Index — are disproportionately exposed to global markets and the industrial cycle. That helps to explain why the S&P 500 has fallen so dramatically at the start of the year, while the U.S. economy has continued to grow. Many smaller, privately owned U.S. companies are not suffering amid the turmoil in China. Meanwhile, publicly traded companies with little or no exposure to China are priced at a premium.

“Stocks that are solely dependent on the domestic U.S. economy and don’t have much overseas exposure are quite expensive these days,” Jonsson noted. “As an investor, at some point, you have to be willing to accept the risk and buy companies with overseas exposure at a discounted rate. Along those lines, we are starting to see some attractive opportunities in health care, technology and a few other key sectors.”

Other potential opportunities are emerging, as strong growth companies with healthy balance sheets seek to consolidate and gain predominant market share. Global M&A activity surged to a record high of more than $5 trillion in 2015 as companies acquired their competitors or merged with firms in other parts of the world to expand their global reach. “Ultimately, these companies will make it through the difficult times and emerge even stronger on the other side,” said portfolio manager Gerald Du Manoir. “We are seeing it in the semiconductor and health care sectors, for example. It’s a way to boost growth and increase future profit streams.”

In this market environment, Du Manoir explained, it becomes a virtuous circle for companies that are in a position to make acquisitions and execute on them. “You reward your shareholders with growth and your stock gets re-rated. This is a huge opportunity for well-managed companies to gain market share and differentiate themselves,” he said.

Stock and Oil Prices Decline Price Returns Since 12/22

Source: RIMES
Equity markets were led lower by the route in China’s stock market, which declined steadily from its recent peak on Dec. 22, 2015. Crude oil has also fallen on fears of oversupply and slackening demand.

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This material is intended for use by financial professionals or in conjunction with the advice of a financial professional.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing. 

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not to be comprehensive or to provide advice.