Mounting signs of capital market stress

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Alvin Douglas
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1 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 JANUARY 22, 2016 ECONOMIC SIT UAT ION AND ST RAT EGY Mounting signs of capital market stress The stock market correction has continued in recent days and major exchanges around the world have registered sharp price declines. The German DAX index, for example, is down by 11.9% in value since the beginning of the year, the US S&P 500 by about 9%, and the Japanese Nikkei 225 by 15.8%. These losses have wiped out the German and Japanese markets' performance in 2015, while investors in the United States already suffered losses last year. Signs of capital market stress have also been mounting elsewhere. Yield spreads between corporate and government bonds have widened again. In the case of European corporate bonds rated BBB, spreads relative to government bonds have been rising since mid-2014 and are now at their level of Rising spreads are usually a signal that capital market participants judge economic prospects more cautiously and expect higher corporate default rates in the future. In the past, the bond market has regularly anticipated changes of economic trend better and has caused fewer false negative signals than the stock market has. 2,0 1,8 Bond market: Yield spread IBOXX Euro corporates BBB - IBOXX Euro government bonds (percentage points) extent downside risks exist for the economic outlook or whether political and geopolitical factors might lead to further price losses on the stock exchanges. On the other hand, questions about possible opportunities this year have receded almost entirely. In fact, the downside risks in 2016 appear especially pronounced. Regarding the economic prospects, the International Monetary Fund has recently revised its growth forecasts downward by 0.2 percentage points to 3.4% for 2016 and 3.6% for The decisive factor for this more cautious outlook is the expectation that growth in the emerging markets will continue to slow. The IMF also expects somewhat weaker growth for the industrialized countries, but its revisions for them are much smaller. This forecast underscores that the economic risks have increased somewhat. We share the IMF's assessment in that respect. At 3.2%, our expectation for world economic growth in 2016 is even a little more cautious. Overall, however, economic output would thus grow about as strongly as in But an economic dip or even a new recession, for which world economic growth would have to fall below 2.5%, is not to be expected. 10% Global economy: OECD leading indicator and industrial production 103 1,6 1,4 1,2 1,0 0,8 0,6 0,4 0,2 0,0 5% 0% -5% -10% -15% Whether this is the case in the current environment certainly must be questioned. For one thing, the ECB is purchasing government bonds on a large scale, which is depressing their yields. Practically, this is almost necessarily increasing the yield differences between corporate and government bonds. For another, the central bank's huge interventions and, above all, tighter regulations on banks are having the undesired side-effect of decreasing liquidity in the corporate bond sector. Consequently, even bonds from companies with top credit quality can no longer be traded on a large scale or, if so, only at price discounts. The medium-term consequence of this development could be that investors buy government bonds even at significantly lower yields because they can dispose of them again practically at any time. In contrast, companies have to pay higher interest because their bonds can only be traded, if need be, to a limited extent in stress situations and not at all in the worst case. Nevertheless, the difficult situation on the stock and bond markets now is weighing appreciably on investor sentiment. The question is being raised more urgently to what Industrial production (y/y) OECD leading indicator BRIC countries (r.h.s.) OECD leading indicator industrialised countries (r.h.s.) Furthermore, for the first time in a long while, the economic situation in the emerging markets has stabilized somewhat from very low levels in the past months. Whether this will be a sustained trend is not yet foreseeable, but it is conceivable that the pressure, e.g., from Brazil and Russia, which were deep in recession in 2015, will diminish. It is also possible that more relaxed monetary and fiscal policy in China will gradually work and growth rates will not decline as significantly as some market participants fear. On the other hand, greater doubts exist regarding the US economy, where the manufacturing slowdown appears to be continuing. This poses the potential risk that the weakness will spread to the labor market, the services sector, and consumer spending. However, there have so far been few signs of that, and we continue to expect real growth of the US economy by about 2%. But even investors who basically share this economic outlook are plagued by doubts these days. A risk that is hard to quantify, so the objection goes, is posed by falling commodity prices and particularly by the low prices quoted for 1

2 Jan. 14 Feb. 14 Mrz. 14 Apr. 14 Mai. 14 Jun. 14 Jul. 14 Aug. 14 Sep. 14 Okt. 14 Nov. 14 Dez. 14 Jan. 15 Feb. 15 Mrz. 15 Apr. 15 Mai. 15 Jun. 15 Jul. 15 Aug. 15 Sep. 15 Okt. 15 Nov. 15 Dez. 15 Jan. 16 crude oil. As a rule, it is accepted that the price decline has not been triggered by falling demand, but rather by significantly rising supply. 11,0 USA: Bank of America Merril Lynch High Yield Master 2 Index (Yield in percent) Oil price: Average oil price of Brent and WTI and demand backlog in % 10, ,0% 1,5% 1,0% 0,5% 0,0% -0,5% -1,0% -1,5% -2,0% 9,0 8,0 7,0 6,0 5,0 Demand backlog in % (r.h.s) Average oil price of Brent and WTI This may be observed very well in the case of crude oil, where a kind of spiral has been set in motion. Since prices are dropping, the revenues of the companies and oilproducing states are also falling. Consequently, even more is being produced in order to make good the absolute revenue losses, and the price keeps on falling for the time being. This mechanism is also taking hold in the case of other commodities, but is often less pronounced there due to lower state influence. For, while independent companies are increasingly being forced out of the market given such a price spiral, companies supported or controlled by the state can hold their breath for quite a long time before they or even the relevant state get into financial difficulty themselves. However, that is also exactly where the risks lie that investors fear. Economic difficulties or even the bankruptcy of oil and commodity companies and of countries that export crude oil could set off a chain reaction leading in turn to negative effects in the real economy by way of the capital market. This danger cannot be ruled out entirely. As we pointed out the week before, relatively large sales of sovereign wealth funds might have contributed to the stock market correction. This would be a serious sign that the current spending policy of commodity-rich countries has long not been covered by their revenues. Either government budgets are cut, which may lead to further economic difficulties a poor option in view of the political tensions in many commodity-rich countries or assets continue to be sold, and debt increased. This may prove a sound strategy as long as the downturn on the commodity market does not persist. But in any case, we also see the dark side of the commodity price slump here. And the pressure on companies continues to mount. This can be observed, for example, on the highyield market in the United States. Yields on bonds of energy companies there have risen to more than 18%; the number of corporate bankruptcies is likely to skyrocket in this sector as soon as the first refinancing transactions become necessary. That could cost jobs and further dampen demand for capital goods. However, we do not see a threat of relatively largely distortions on the capital market if some companies should disappear from the market. Furthermore, it should not be forgotten that practically all analysts still forecast a decent year for the economy at the beginning of 2015, precisely because crude oil prices had fallen so sharply. Those forecasts have certainly proven correct at least with a view to consumption in the industrialized countries. Consumers have used rising purchasing power for additional spending. The very good sentiment in the services sector, not only in the United States but also in Europe and even some emerging markets, is also likely to have been partly attributable to that. But we have the impression that these positive effects, due to the actions of many agents, now weigh less in the eyes of investors than the negative effects of a few, which are clearly visible and in some cases precisely quantifiable. We do not share this skepticism without qualification, but in any case the low commodity and oil prices are currently affecting sentiment negatively and contributing to market jitters. The most difficult task is to evaluate political risks, which have undoubtedly increased compared with last year. The growing lack of political unity in the European Union is particularly weighty. If that should lead to a lasting disruption of the single European market, it would threaten serious consequences for economic activity. Moreover, the danger exists in this connection that the will to continue the European Monetary Union could come into question again on the capital market. Here, it is urgent that political decision-makers become aware of their responsibility. Past decisions made to allow with sufficient certainty that such developments could be ruled out in the future have in any case not kept pace or been adequate to the needs and seriousness of the situation. However, it is questionable to what extent this set of issues has contributed to the stock market correction. We have the impression that investment decisions on some European stock exchanges (e.g., in Portugal) have lately also been influenced by political risks. But there have been no large distortions on the bond market. So far, the ECB's policies are still a guarantor that the crisis signals have largely been absent at least on the government bond markets. In our opinion, the discussion has hardly taken note that a stock market correction can also offer opportunities. Besides the presumably exaggerated concerns about a severe global economic slowdown, which might be replaced by a somewhat more positive perspective, valuations on the 2

3 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 Aug-14 Feb-15 Aug-15 Jan-14 Feb-14 Apr-14 Jun-14 Jul-14 Aug-14 Oct-14 Dec-14 Jan-15 Feb-15 Apr-15 Jun-15 Jul-15 Aug-15 Oct-15 Dec-15 Jan-16 Feb-16 stock market have become somewhat more attractive. For example, the price/earnings ratio (P/E) on the DAX is at 11.9 points according to I/B/E/S estimates, which is about the level at the beginning of On the broad US stock market, as measured by the S&P 500, the P/E is now as high as it was in October DAX and S&P 500 Price Earnings Ratios DAX S&P 500 Valuations have thus become somewhat more attractive, which argues in principle that higher earnings are possible in the future. However, from a timing perspective, valuation aspects are not very helpful. Cheaply valued stocks or markets may also become even cheaper. Against this background, the current valuation markdown may not be large enough yet for some investors. It should be noted, however, that valuations have tended to drift further apart. Defensive and/or high-priced sectors have hardly become more attractive on the valuation side in the correction, while cyclical sectors have registered a significant markdown. Thus, for example, the P/Es of the food sector (-2.8% m/m), utilities (-0.5% m/m), and telecommunications (-0.9% m/m) have hardly declined. On the other hand, the P/Es of the automobile sector (-12.6% m/m), chemicals (-7.4% m/m), and industrials (-5.4% m/m) have fallen sharply. That certainly also reflects the fact that earnings in those sectors would come under pressure if the economy should lose momentum. At the same time, the cushion against disappointments has now become larger and could offer cheap entry opportunities in those sectors in case of a calming on the stock markets. US Treasuries have fallen below 2%. Comparing this with the reciprocal of the P/E ratio (which corresponds to the earnings expectations for stocks in the coming 12 months) yields an expected excess return for German stocks versus Bunds of more than 7%, and for US stocks versus Treasuries of about 4.5%. In Germany, this corresponds roughly to the values that were reached during the financial crisis. In 2011, the risk premium was even higher and has meanwhile gone above 10% at times. In the United States, the number was last higher in 2013 and ranged between 6.5% and 7.5% in the financial crisis and Measured against that, the skepticism of stock investors in Germany is already very high, while no real crisis mentality has taken hold on the US market so far. Of course, it is possible that (significantly) higher risk premiums are being paid again for stocks in the current correction. But as soon as the risks decrease or the fundamental environment visibly improves, stocks could quickly achieve significant outperformance especially in certain sectors and versus alternative investments. The capital markets are likely to remain very demanding for investors in the foreseeable future and might continue to swing sharply up and down. Overall, it is our impression that a comparatively balanced and widely diversified positioning is appropriate in the current situation. It would be a serious mistake to underestimate the risks that actually exist. But it would be equally wrong to judge the prospects too pessimistically and "freeze up" in shock. Even though little is being said about opportunities now, they could still arise for investors in the course of the year. Stoxx 600: PE of most expensive sector - PE of least expensive sector (difference in points) Moreover, the risk premium for stocks versus bonds has increased in many countries. The 10-year German government bond (Bund) is now quoting under 0.5%, and 10-year 3

4 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13. Weekly outlook for January 25-29, 2016 Sept. Oct. Nov. Dec. Jan. Feb. Release DE: Ifo business climate January 25 DE: GfK consumer climate January 27 DE: Inflation rate, flash estimate, y/y 0.0% 0.3% 0.4% 0.3% 0.6% January 28 EUR19: Consumer confidence January 28 EUR19: Business confidence January 28 EUR19: M3 money supply, y/y 4.9% 5.3% 5.1% 5.0% January 29 EUR19: Inflation rate, flash estimate, y/y -0.1% 0.1% 0.1% 0.2% 0.4% January 29 MMWB estimates in red Chart of the Week: ECB arouses expectations again ECB main refinancing rate (%) 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 As expected, the European Central Bank has left its key interest rate unchanged. The deposit rate has also remained untouched. ECB President Mario Draghi touted the measures, not decided until December 2015, as working and appropriate. However, Draghi also said that downside risks for the economy and inflation had increased again lately, so that in its next interest rate decision in March, the ECB would review not only its assumptions for euro zone inflation and growth, but also whether the nature and extent of the measures employed are sufficient to meet its inflation target. Draghi has thus once again sought to prepare market participants for more accommodative monetary policy in the future. Whether the glad reception of the announcement now made will last remains to be seen, however. For, the central bank was for the first time clearly lagging behind consensus expectations with its decisions in December It seems to be increasingly difficult to organize majorities in the ECB Council for more accommodative monetary policy. Therefore, the upside expectation that the central bank could print even more money in the future is no longer worth as much as it was before. 4

5 As of Change versus Stock markets 13:37-1 week -1 month -3 month YTD Dow Jones ,7% -7,9% -7,5% -8,9% S&P ,6% -7,5% -7,4% -8,6% Nasdaq ,4% -10,0% -7,6% -10,7% DAX ,3% -8,8% -6,5% -10,9% MDAX ,9% -8,7% -6,9% -10,4% TecDAX ,5% -9,7% -8,4% -11,4% EuroStoxx ,3% -8,4% -10,0% -9,9% Stoxx ,4% -7,7% -10,2% -10,0% SMI (Swiss Market Index) ,9% -6,0% -6,6% -8,9% Nikkei ,6% -15,3% -13,7% -15,8% BOVESPA ,4% -12,9% -19,9% -13,2% RTS 632-3,2% -16,7% -26,2% -16,5% BSE ,0% -6,9% -12,2% -8,3% China Shanghai Composite ,7% -20,9% -13,3% -18,6% MSCI Welt (in ) ,3% -8,8% -6,7% -10,0% MSCI Emerging Markets (in ) 689-2,7% -13,2% -16,5% -13,3% Bond markets 3 months $ Libor 0, year US Treasuries 2, year Bunds 0, year JGB 0, US Treas 10Y Performance 577,16 0,1% 1,7% 0,4% 2,3% Bund 10Y Performance 592,51 0,8% 1,6% 1,9% 2,3% REX Performance Index 478,92 0,4% 0,7% 1,1% 1,0% US mortgage rate 3, IBOXX AA, 1, IBOXX BBB, 2, ML US High Yield 9, JPM EMBI+, Index 694 0,1% -0,9% -2,6% -1,4% Convertible Bonds, Exane ,0% -4,5% -3,1% -5,5% Commodities CRB Index 358,74-0,1% -4,0% -11,1% -5,4% MG Base Metal Index 218,30 0,8% -5,0% -12,6% -6,0% Crude oil Brent 27,98-9,8% -24,3% -41,9% -23,4% Gold 1093,94 0,3% 1,4% -6,2% 3,0% Freight rates Baltic Dry Index 355-4,8% -25,7% -54,5% -25,7% Currencies EUR/ USD 1,09-0,2% 0,2% -4,1% 0,1% EUR/ GBP 0,77 0,0% 4,4% 4,3% 3,9% EUR/ JPY 127,43-0,3% -3,4% -6,5% -2,8% EUR/ CHF 1,09 0,0% 1,3% 0,8% 1,1% USD/ JPY 116,94-0,1% -3,5% -2,5% -2,8% Carsten Klude cklude@mmwarburg.com Dr. Christian Jasperneite cjasperneite@mmwarburg.com Matthias Thiel mthiel@mmwarburg.com Martin Hasse mhasse@mmwarburg.com Dr. Rebekka Haller rhaller@mmwarburg.com This report does not constitute and shall not be construed as an offer or an invitation to make an offer. It may only be used as guidance and to illustrate potential business activities. No claim is made as to the exhaustiveness of the information contained in this report, and it is therefore non-binding. The opinions expressed here may change at any time without notice. Any statements made about prices or interest rates or any other indications that are given relate exclusively to the time that the report was produced and do not contain any statements about future trends or, in particular, about future profits or losses. In addition, this report does not constitute and shall not be construed as advice or a recommendation. Before concluding any transactions presented in this report, you should always obtain client- and product-specific advice. 5

ECONOMIC SITUATION AND STRATEGY

ECONOMIC SITUATION AND STRATEGY 7,2 8,4 9,2 9,8 10,3 10,8 11,3 11,8 12,2 12,7 13,2 13,6 14,1 14,6 15,2 15,9 16,6 17,5 18,6 20,0 22,2 25,4 33,0 2.304,0 MARCH 7, 2014 Stocks: Low valuation pays off We made the case here a few weeks ago