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Return of market volatility?

In recent weeks, there has been a marked increase in volatility in investment markets worldwide. Two main sources have been dominating thoughts – the Greek debt crisis and falls in the value of the Chinese stock market.

Old Mutual Global InvestorsIn recent weeks, there has been a marked increase in volatility in investment markets worldwide. Two main sources of uncertainty have been dominating investors’ thoughts – the ongoing Greek debt crisis and falls in the value of the Chinese stock market – with knock-on effects for equity and bond markets far beyond the affected areas. In this note, we discuss these events, as well as what they have meant for the portfolios we manage. 


Source: Bloomberg as at 7 July 2015

The eurozone’s Greek tragedy played on….

News that a deal had been reached between Greece and eurozone authorities on the morning of 13 July, after months of increasingly frantic negotiations, was not just greeted with sigh of relief from eurozone politicians. After remaining relatively sanguine for much of the year to date (indeed, European stock markets have been amongst the best performers in the world in 2015), the surprise referendum called by Greece for the 5 July came as a nasty shock. 


Source: Factset, as at 7 July 2015

After sharp falls in markets in the last days of June, the increasingly positive news has seen European equities regain these losses. Greek stock markets and banks remain closed, however.

As risk aversion increased, there was a noticeable reversal in the increases in benchmark sovereign bond yields worldwide seen earlier in the second quarter – for example, the German 10-year Bund yield, which had reached 0.92% on the 26 June, fell back to 0.64% by early July. However, news of a deal has seen yields revert close to their previous levels.


Source: Factset as at 7July 2015

Portfolio positioning

We had been generally running an underweight position in both equities and sovereign bonds within our portfolios, so much of these broad movements have tended to cancel each other out in overall performance terms. Within European markets, our main positioning had been an overweight exposure to European equities based on the view that European quantitative easing (QE) should be helpful to European risk asset prices, as it has been in other markets where large QE programmes have been conducted. This positioning has been rewarded so far in 2015, as European company shares advanced strongly. However, given the increased uncertainty caused by the referendum announcement, we immediately closed this position for risk management reasons. Our core thesis looks increasingly likely to remain valid and accordingly we have re-entered the position now that the framework for a deal is in place.

Chinese equities – correction or something else?

After a stellar rise in recent months, the last month has seen sharp drops in the value of Chinese shares.


Source: Factset as at 7 July 2015

Despite this loss in value, China’s domestic stocks listed on the Shanghai stock exchange — known as A shares — remain among been the best performers in the world this year. Much of the stellar rises in the A share market has been driven by a boom in technology related stocks, with valuations in some sectors reaching levels similar to that seen on the Nasdaq exchange during the tech bubble.

Chinese authorities have moved to quell these falls – over the past two weeks, they have cut interest rates, suspended initial public offerings, relaxed margin lending and collateral rules and enlisted brokerages to buy stocks, backed by cash from the central bank.

We hold an overweight position in the Hong Kong equity market, known locally as H shares, recognising its very attractive valuation and ‘margin of safety’ in comparison to other large equity markets globally. This position has been substantially rewarded over late 2014 and most of the year to date, with the market returning to highs last seen in 2007 in April.

The stocks listed in Hong Kong tend to be larger, blue chip names with more focus on the insurance, banking and industrial sectors, so, while gains have been strong, they have been considerably less than those seen on the frothier mainland markets, as can be seen on the previous chart. The H share market trades on a considerable discount to the A share market under metrics such as ‘price to book’ to reflect this.

Unfortunately, because of the more accessible nature of the H shares market, this discount has actually gotten bigger in recent times during the sell-off. This is due to a liquidity effect – when people want to close positions quickly, it is easier to sell the H-shares exposure as a hedge (or for speculative purposes) because they are most liquid and there are no short selling restrictions. 


Source: Bloomberg as at 7 July 2015

We have seen the Chinese equity market as the best example of ‘demerging markets’ – after years of strong economic growth, China is now the second largest economy in the world, and it deserves to be scrutinised as an individual market in its own right, rather than as part of the broader emerging markets region. The country remains set on a path of rebalancing the economy from a reliance on investment to a broader focus on consumption to drive progress, with continued government stimulus backing to drive this proc. Growth continues to hold up, with a rate of annual GDP growth of 7% p.a. announced for the second quarter earlier this month. We believe the efforts of the Chinese authorities to limit further losses – combined with this strong Chinese economic news, and the discounted nature of Hong Kong-listed Chinese shares relative to other markets worldwide – means that our overweight position will be further rewarded from here.

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