Despite rocky start, opportunities exist for investors

Global equity markets began 2016 with such sharp declines that up until the final days of last week, investors were on track to have recorded the worst start to the year in history for several global markets.

The main drivers of the decline across asset prices in January included renewed doubts in the Chinese economy and the extent to which the country’s currency may devalue and the continued decline in energy and other commodity prices.

Indeed, there is an economic slowdown in China, but this is not a new development.

In fact, the Chinese economy has been slowing for some time and activity levels within the country are likely to be well below the centrally controlled economic statistics released by the government.

While asset markets appear to be treating the developments in China as an indication of an impending global slowdown, it is more likely that the ongoing slowdown in the country is becoming more difficult to control without weakening the currency.

A gradual reduction in the value of the yuan will serve as a form of stimulus for the Chinese economy but it will export challenges to the rest of the world, which are manageable provided the rate of decline in the currency is not an outright significant devaluation.

In the case of oil, 2016 began where the prior year finished and the world remains oversupplied with crude and further production coming on stream from Iran served as a further drag on sentiment.

With prices per barrel falling to below $29 at their low point, oil was down 20% in just a matter of weeks, to a multi-decade low.

At those prices, it becomes uneconomic to produce oil in very few places other than the Middle East, giving OPEC’s Saudi Arabia, a distinct advantage over other producing countries.

With oil prices so low, and emerging market currencies that include the Russian Ruble and Mexican Peso collapsing, the situation may bring about a self-correcting solution should OPEC and Russia finally agree to sit down and agree to reduce production levels.

The difference between OPEC declaring success at crushing US production growth or being vilified for bringing about the collapse of other OPEC members is slim.

At these price levels, the strategy that Saudi Arabia is driving could quickly become uncontrollable as storage capacity for all of the oil that is being produced is becoming increasingly scarce.

If an agreement between the oil producing majors is not reached, there is a real chance that oil prices could lurch even lower, but should rational thinking prevail, it would now be a perfect time for the right people to sit down and hammer out an agreement.

So what should investors expect in 2016?

While equity markets have experienced significant declines in the opening weeks of the year, we believe that the frenetic pace of selling will give way to an excellent opportunity to invest in companies sold off by virtue of being publicly listed despite their underlying assets and operations remaining attractive.

While market volatility can be unsettling, it should not overly divert from an investment’s medium term fundamentals and we would use weakness to selectively add market exposure while maintaining holdings of quality companies.

We think that it is likely that OPEC will alter their current strategy and that oil prices will likely bottom over the coming quarter. Given the increase in deflationary forces on a global basis, we expect that central banks will be forced in to further monetary stimulus to try and generate inflation, led by the European Central Bank and Bank of Japan, which will likely lift asset prices.

As a result, we believe that 2016 will very much be a stock picker’s market and one that will be subject to high volatility.

We would forecast that global equity markets will produce a return of between -5% and +5%, but with the scope to trade in the range of +/- 15%, with the downside risk more skewed to the first quarter of the year.

Investors that focus on identifying companies with strong underlying business models, competent and capable management teams and that trade on valuation multiples which offer a margin of safety should stand to benefit from what will likely be a volatile market, with as many moving parts as we saw in 2015.

David Holohan is chief investment officer of MerrionCapital Group


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