Tuesday 10 December 2019

If you can keep your head, this carnage could deliver you double-digit returns

The market has priced in a lot of risk, writes Ian Quigley

Market opportunities are never far away
Market opportunities are never far away

Ian Quigley

There is no doubt that equity markets remain challenging, with disquieting levels of volatility. This is the most challenging market environment we have faced in several years, so it is understandable that anxiety levels are rising.

It is therefore helpful at times like this to take a step back and look at the history of market corrections and to ask what may or may not be getting priced in. If we look at the MSCI All World Country Index, we see that the average peak-to-trough correction since the late 1980s has been around the 12pc mark.

We also see that bear market declines, when the US economy has avoided recession, have ranged between 20pc and 25pc. The most recent example of such a decline was 2011, when the world equity market fell 24pc before staging a very strong recovery.

However, it is noteworthy that declines have been much deeper and prolonged when the US economy has entered recession, with an average peak to trough fall of about 45pc. The health of the US economy is therefore a critical variable when assessing further market risk.

So what has the market fallen, peak to trough, this time? Well, from last year's high to the most recent low, the global equity market is down about 20pc in US dollar terms and around 24pc in euro terms.

While this analysis may seem overly simplistic, we believe it tells us that a lot of downside economic risk has been priced into equity markets over the last few months.

Indeed, if it proves that the global economy avoids recession, which we believe it can, then we have likely observed the vast majority of the downside and we should be feeling better about equity risk from this point.

Even if the global economy does slow more than we think, which is perfectly possible, the above analysis would also suggest that we have seen the great majority of the falls.

Clearly, a scenario whereby the US falls into recession would warrant a more cautious stance. However, we view this as unlikely, given the continued recovery of the domestic US economy, which accounts for about 70pc of US GDP.

While we, of course, do not discount the potential for further declines, we do believe the risk/reward from equities is looking increasingly attractive for long-term investors at this point. The view is further supported by sentiment analysis, which shows that after periods of investor panic, such as that which we are witnessing, subsequent returns tend to be well above average.

The other development we would like to comment on this week is the extreme divergence within equity markets, with our preferred universe of high-quality multinationals massively outperforming more cyclical equity assets of late.

Indeed, this divergence is now testing historical extremes, such that it would not surprise us to see a reversal in this trend for a period, with some 'beaten up' cyclical assets outperforming.

For us, this presents somewhat of a dilemma, given our preference for higher-equity quality assets. We are addressing this challenge by allocating to a number of more value-oriented managers.

With equity markets discounting a lot of bad news and cyclical assets trading at depressed relative valuations, we believe it would be a mistake for medium- to long-term investors to become too defensive at this point.

We are not calling the bottom - and indeed we retain plenty of flexibility to add to equities, should markets weaken further - but we are definitely finding opportunities amid the market stress.

Ian Quigley is the head of investment strategy at Investec Bank.

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