China has taken a large part of the blame for the market ructions so far this year. January’s selling appeared to kick off after a weakening in the Chinese currency, and some poor industrial data was coincident with a change in sentiment.
But assigning the blame to China may be missing the point.
Developed market stocks are overvalued and stock market gains have been driven by an “ever narrowing group of predictable earners”, according to Kerr Neilson, founder and chief investment officer of Australian money manager Platinum Asset Management.
In a note to clients last week, Neilson didn’t say China wan’t important. He simply highlighted that the focus on China has been late to the game and much of the bad news might already be priced into the current market focus on emerging economies (our emphasis):
While the media is likely to cast China as the centre of the current instability in markets, the point will be lost that the dice was long cast when it doubled outstanding credit in the three years after the GFC, and by so doing, provided respite for all. With prices having already declined 40% across emerging markets since 2011, current poor sentiment has already been well, if not fully, expressed in their share prices.
Neilson does highlight how China has shined the light on stock valuations in developed markets.
He says that China’s “underutilised factories will try to find markets abroad with deflationary effects on prices and this will wash across broad categories of products (companies) via weaker profits and in pure commodities, weak demand and prices.”
That’s a threat to western stock markets, Neilson says.
It is this pressure on company profits in a world that has too much debt (much higher now than at the outset of the GFC) which tends to impede growth that is alarming investors. Valuations in so-called developed markets are high as investors had sought safety by investing in an ever-narrowing group of ‘predictable’ earners. Indeed it has been these types of companies that have led many markets higher for the last several years, while commodity producers have been underperformers.
The key now, Neilson says, is that investors have become used to low rates and low inflation and as a result “seem to be less concerned to hold cash and to avoid the uncertainty of equities.”
That’s important because as Ray Dalio, founder of the world’s biggest hedge fund Bridgewater once said, “there are two main drivers of asset class returns – inflation and growth.”
Just this week we saw New Zealand is “on the cusp of outright deflation” while last night ECB president Mario Draghi promised more easing by Europe’s central bank because downside risks have increased for the economy and inflation.
So, as Neilson highlights, lower inflation and growth pressures combine to pressure stock valuations.
But that doesn’t mean that stock picking is dead. Quite the contrary, Neilson says.
Platinum has been “ever more cautious as to the type of companies we wish to hold and the valuations we are prepared to accept”, he says. That has raised the firm’s cash holdings in its funds. And he has been leery of US market valuations with Platinum “shorting it as additional protection.”
So he’s been making money as US stocks fall.
But Neilson is ready to put that money back to work he says.
“We like the valuations of the companies we own across markets from a long-term perspective and have the cash and the benefit of shorts to add to holdings in the event of further weakness.”
Valuation’s not dead. Its just being used as judiciously as Ben Graham and Warren Buffett suggested it should be.
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