Brutal start to 2016 poses questions for rest of year

After another brutal week in financial markets, there is a sense that investors are feeling pretty shell-shocked at the start of 2016, asking the question – can the next 49 weeks be as tough as the past 3 have been?

With many equity indices nursing double digit losses, investment grade credit benchmarks have seen spreads widen by as much on a year to date basis as was the case in the entirety of 2015, underlining the brutal nature of price action across global markets.

Oil prices fell to a new low below $27 per barrel, before bouncing by 10% later in the week and notwithstanding further policy easing, fears surrounding the outlook for the Chinese economy also continued to intensify. Added to this, the notion that sovereign wealth funds are being forced to sell assets in order to meet government revenue shortfalls has added to market worries amid increasingly illiquid conditions.

Last Thursday, Mario Draghi delivered a dovish performance at the European Central Bank (ECB) meeting, which effectively teed up further monetary easing in March. However, with markets having been guilty of over-pricing ECB expectations in December, there has been a sense that action will speak louder than words at this point. Nevertheless, this was still enough to prompt a short covering rally in risk assets from a point where sentiment had become extremely bearish.

This week sees the Bank of Japan deliver its assessment on their policy stance, though away from this, equity investors have also struggled to adjust to a world where there seems little scope for support from the US Federal Reserve should prices continue to fall.

As we look forward, it is now tempting to believe that a bounce in markets is sorely overdue and in the short term we are more inclined to add directional beta risk on the long side via liquid credit indices.

However, the threat of a perfect storm in markets is growing, where structural illiquidity, fund redemptions, negative external shocks and an absence of policy support could all come together at the same time to create a systemic loss of confidence.

Quantifying this risk is difficult, but what is clear is that the movements in markets have been extreme and projections made a relatively short time ago already look out of date. For example, we believe that Euro inflation could now dip as low as -1.0% in the months ahead if oil remains in the 20’s. Meanwhile, in a country such as Saudi Arabia, a projected fiscal deficit for 2016 at -15% of GDP could now exceed -30% on our analysis, even after making cuts to government spending.

What also seems clear is that 2016 could be a turbulent and volatile year in global financial markets.

Uncertainty reigns for the time being, but we feel confident that trends between gainers and detractors will grow increasingly stark and in this there could create material investment opportunities. We believe that we are well placed to be buyers on weakness and sellers of strength, but clearly after a difficult few weeks are hoping to see a better end to January than it has started.

 

Mark Dowding is partner & co-head of Investment Grade Debt at BlueBay Asset Management

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