Move in the right direction
The infinite discussion about the right stock price is often an assessment of the individual components in the pricing model used to calculate the “right” price on single stocks or an index. It is a fair and natural way to consider stock markets as company earnings, dividend payments, expected macroeconomic indicators, inflation, etc. are included in the calculation. But after the first quarter of this year, which was dominated by severe unease, I did for a period expect to pay increased attention to “unease factors” that don’t fit into a pricing model – if I was selling headlines I would call it “fear factors”.
THE CREDIT SQUEEZE
The “unease factors” can beat all other rational models or good arguments and they might hit the stock market hard as unease can spin into fear. One example is the oil price that will remain low for a longer period than expected. It’s of course the oil producers who lose, whereas Western consumers and oil-importing countries are the winners. It’s widely known that the net effect for the U.S. currently is negative because the consumers are saving the extra money they have at disposal due to dropping energy prices. It’s fascinating to consider that the latest meeting in Doha could have sent the oil price higher and thereby reduced the stress amongst American oil producers – plus in the U.S. credit market.
The rings in the water from the battered U.S. oil industry are still spreading into the American economy. It is well known that the default risk in the oil sector has sent interest rates for the sector up in the sky if oil producers as a whole can find financing at all. It’s visible in graphic one showing the return for investors placing their money in a basket of debt issued by U.S. companies with low credit ratings (CCC or lower in Standard & Poor’s terms and thus high-yield). The high return includes a bankruptcy risk in the oil industry and therefore the return is not representative of the financing costs for all businesses in the U.S. with the same rating. The interest rate for U. S. companies with a CCC credit rating is currently around nine pct. What I closely follow is if the credit market for companies with a low credit rating will tighten in general. My impression is that signs are towards a tightening credit market although some investors are attracted by the high returns shown in graphic one and therefore invest in corporate bonds with low credit ratings via investment funds.
Right now there is not a mountain of corporate debt to be refinanced. This is quite good as the number of corporate bonds that defaults in the United States is rapidly increasing. The payment problems are almost solely among companies in sectors related to commodities so there is currently no widespread effect for the corporate sector. However, recently Europe also was hit as the Norwegian company Norske Skogindustrier had to give up.
I am very aware of negative changes in the credit market for companies with lower credit ratings, as I expect such a development to weigh negative on the stock markets. The best way to mitigate the development is improved company earnings however the upcoming earning season might show that it’s difficult. Should credit markets tighten, then the only way for a number of companies is to issue more shares which obviously would be at the wrong time.
THE SOLUTION IS SOUGHT ELSEWHERE
It is well known that investors seek any kind of return which also results in an increased capital flow towards private equity and venture capital funds. The idea for a venture capital investor is to invest in companies before they are listed and thus achieve a higher return plus of course running a higher risk. Naturally, there is some correlation between the stock market and venture capital investments which means that the pricing of similar companies will have some similarity in both markets. But venture capital investments are predominately in companies within upcoming and new sectors like technology. An open question for me is just how much negative effect a potential disappointing development in the venture capital market can have on the stock market? – This could be another “unease factor”.
Currently, there are about 170 venture capital financed “unicorn” companies in the United States – “Unicorn” is the status an entity obtains when the expected market value exceeds 1 billion U.S. dollars. The vast majority are technology companies originating from Silicon Valley. The challenge is though that many companies struggle to retain the market value after the IPO on the stock exchange. What I keep an eye on is the possibility that the technology sector in a broad perspective is overvalued – that would certainly be an “unease factor”. I really see this as a very real risk since many explosive company valuations are based on the belief that a concept or a technology can breakthrough with exponential global growth. I give this “unease factor” attention because I regard it as a growing risk that too few “unicorns” meet investor expectations. This risk doesn’t have to materialize though if it happens I argue that it will have a spill-over effect on the stock market.
I expect that a growing number of “unease factors” will cause increased volatility in the stock market throughout the year and include a sense of fear. Therefore I argue that investors will be more selective by actively selling off companies, countries, and sectors that will have a hard time through the coming years with low global economic growth.
For those who consider a more selective approach then it’s no secret that I am pretty downbeat on continental Europe and I recommend reducing this region further. There are no signs of progress in Europe (excluding the UK) so I still cannot find a better alternative than allocating more to Asia. The drop in oil prices and other commodities I would have expected to cause more stress among companies in emerging market countries than currently can be observed. Graphic two shows return on debt from BBB-rated companies in Emerging Market countries, which in no way indicates concerns among investors.
This index covers not only Asian companies, but in Asia, I still argue that it’s possible to find the most investment opportunities. A number of countries have high GDP growth, many countries have healthy public finances and there is an increasing number of households with growing purchasing power.
Therefore MSCI once again is examining whether China’s A-share market should be included in the Global MSCI EM index. Despite the fact that MSCI shelved the plan after the volatility in China’s domestic stock market last year. Even for MSCI, it seems obvious to move towards China and load A-shares in the cargo. I can only repeat that the best thing to do for a stock portfolio in the coming years is to select economic growth – that would be a move in the right direction.
