Legg Mason Affiliate Investment Managers Assess Recent Equity Downturn
In Searching for Macro Answers to Sudden Losses, They Also See Unique Opportunities Active Managers Can Deliver for Investors
13 Jan, 2016, 09:30 ET
NEW YORK, Jan. 13, 2016 /PRNewswire/ -- Reacting to the recent downturn in global equity markets, and seeking to reassure investors who are searching for answers, Legg Mason brought together four senior investment managers from its affiliates for a market update webcast. They included:
- Francis A. Scotland, Co-Director of Global Macro Research, Brandywine Global
- Scott Glasser, Co-Chief Investment Officer, ClearBridge Investments
- James H. Norman, President, QS Investors
- Michael C. Buchanan, Deputy Chief Investment Officer, Western Asset Management
Matt Schiffman, Legg Mason's Head of Global Marketing, set the stage by observing: "The Dow Jones Industrial Average was down 1,000 points, the worst five trading days ever. The S&P 500 was down 6 percent, the worst start to a year ever. In Europe the Stocks Euro 600 was down 6.7 percent. The Shanghai Composite was down 10 percent for the week ... Roughly $2.5 trillion dollars of market value was lost in the global equity markets last week."
While no one claimed to have a complete explanation, many thoughts and theories were posited.
"There's been a loss of confidence in the last month," Francis Scotland of Brandywine Global observed. He attributed it to a tightening global liquidity position; and capital coming out of financial assets worldwide.
"Those two things have really been responsible for the weakness you've seen to start off the new year," he said. "Let's put it into context. You have a mature bull market, the seventh year. We've already had a narrowing in terms of market breadth, meaning the number of stocks participating has been narrowing over the last year, and more significantly over the last month or two. The result is a market that is very vulnerable to negatives. As negatives become more pronounced, the market becomes vulnerable. The end result is we are in a correction that's ongoing."
"I don't expect it to be an extreme correction," Mr. Scotland declared. "As a manager I like to use volatility to my advantage. I'm seeing compelling values come to the surface in U.S. stocks. The values tend to be in technology, financials, health care. A number of dividend growth stocks appear attractive. Quality-oriented stocks are doing better. That's where the opportunities are."
"So we're in a correction, and it will probably end with a flush," he said. "A flush is a more extreme downside, where we really wash it out. We're not there yet, but you are creating values that are starting to come to the surface in a much more significant way. That's encouraging."
James Norman of QS Investors shared some of Mr. Scotland's views, and words.
"We are definitely in a correction phase," Mr. Norman said. "People are re-evaluating where opportunities are. It's hard to predict because a lot of it will be based on what investors believe. There's going to be a lot of behavior involved in this. If people are nervous, markets will become more volatile. I think investors are nervous. We'll have a lot of uneven economic data: some will surprise on the upside, some will surprise on the downside. It's going to be very mixed."
"Going forward you need a diversified portfolio. Make sure you're not exposed to too much of any individual economic risk or macro risk, whether oil prices, or China, or any of the things that China affects, and so on. That really is the best course of action. But it can go either way. If you look further out – three to five years – we think equities will be a very attractive place to be. However, it's going to be a very bumpy ride over the next three to five years."
Scott Glasser of ClearBridge Investments thinks the markets have retained many positives.
"For stocks that are growing their earnings and giving capital back it is a fine environment," he said. "The valuation of this market should not be a substantial headwind. General valuation is a poor market timing tool, unless it's at an extreme, and we're not at an extreme."
"I'm not putting a lot of weight on the election," Mr. Glasser continued. "I don't think investors are. I'm not putting a lot of weight on the first five days either, as far as historical studies go. I read all those, I find them interesting, I find them sometimes amusing, but that's about it."
"We're coming out of a period where we've had extremely low volatility, a function of a QE regime that had been in place for five plus years. Easy money and ultra low or zero interest rates promote a low volatility environment. We're going back to normal and volatility will go back to at least normal. My expectation is to see higher volatility over the course of the next year."
"I don't mind volatility," he said. "From a client perspective it's not fun to go through, but I think from a portfolio manager's standpoint it actually gives us better ability to add value."
Equity turmoil has been generating the headlines, but fixed income is facing its own challenges.
"It's been different in fixed income versus the equity markets, post-crisis," Michael Buchanan of Western Asset Management said. "The equity markets have been in a lower volatility mindset the past few years. In fixed income, we have been operating with higher volatility, especially in spread products, the sectors that are less liquid. There's two forces driving that and unfortunately those forces remain in place so we should continue to expect elevated fixed income volatility."
"I agree that volatility is something you can take advantage of," he said. "Certainly it's painful on the downside but the flipside is it does work both ways."
"One answer to what's driving this increase in volatility is regulatory. Post-crisis, many firms – especially dealers and market makers – have been operating with a higher level of regulation, whether Volker Rule, Basel III, you name it. They're operating defensively, with less inventory."
"The inventory dealers maintain on their balance sheet is important because although it's a relatively small piece of risk capital for the functioning of fixed income markets, it's a very important piece," said Mr. Buchanan. "Regulatory forces have reduced or shrunk that layer of marginal risk capital at a time when markets continue to grow, so the impact is more pronounced. The market making ability we enjoyed pre-crisis, although still there, is much less significant. That's definitely having an impact on volatility and I don't see that changing."
"The other factor is risk profiles overall. When they think about any market stress movement, asset managers' immediate reaction is to think about their 2007/2008 experience; a lot of risk models now have to factor that in. That was a real outlier in the amount of volatility. If we're operating with that in mind, as an investment manager, it makes you – I would say less willing to pounce on opportunity than you were previously. So there's much more caution in the market."
"These two forces combine to explain a lot of the volatility in the market," Mr. Buchanan said. "The key point is that, especially given where valuations are now, you can take advantage of this opportunity. As much as it hurt in 2015, it's likely to contribute to performance in 2016."
Asked what might have happened in the last week to change their outlook on international equities, Mr. Norman declared, "Our view hasn't changed that much. Our investment theses have been in place and we've done quite well during this time period."
"Global equity markets have really had quite a strong six years plus," he said. "The things that had been very cheap six years ago have now gotten not cheap, and arguably maybe a little bit towards the upper end of normal. That's sort of like a rubber band. When that rubber band is pulled tight, it's much more sensitive to somebody pulling at it and vibrates a lot more."
"Three things we're focusing on, that are going to drive a lot of the volatility but also a lot of opportunities because there's a lot of dispersion, are: we are at fair valuations; investors are worried about growth going forward, but it's going to be slow growth; and macro risks, since people are more sensitive to them when valuations are towards the higher end. Whether it's China, oil, the U.S. Federal Reserve raising rates, people just become very concerned."
"Because of that we're seeing a lot of dispersion in individual country returns," Mr. Norman said. "We're also seeing a lot of dispersion in sector returns, so there are very large differences."
"All markets will see a high correlation but a very different magnitude of return," he said. "Last week developed markets were down 5 to 10 percent. In emerging markets you saw a wider difference – some were down only one percent, others were down 15. We saw more defensive sectors like utilities, staples and telecoms down one to three percent, whereas more cyclically-oriented areas like technology, financials and materials were down five to seven percent. That's globally but we saw a similar pattern in the U.S. as well. We think that's going to continue."
How China's economy will fare – and impact the U.S. – also created significant discussion.
"They don't inspire a whole lot of confidence about what they're trying to do," Mr. Scotland said. "Philosophically, this is an economy where success has been measured by their ability to control the outcome. Moving forward, they really should be measured in terms of letting go."
"This contradicts their whole philosophy about economic development. I don't think these are going to be very smooth events as they unfold over the next year or so. The Communist Party gets its legitimacy from sustaining employment; that's their unwritten social contract. They will do what they have to do to keep the economy expanding and avoid a situation where things become so negative that employment starts to suffer."
"I absolutely agree," Mr. Norman said. "China will be sort of a lumbering awkward teenager trying to figure it out. But at the end of the day, they will figure it out, because they have to. They're also really a state-controlled economy and they will make it work – whatever it takes."
"There are things in their favor. They have low government debt and a huge reserve; they're still at $3 trillion even though they spent a lot last year. The Renminbi was down about five percent last year versus the euro, down 10 percent versus the U.S. dollar, and the Canadian dollar down 20 percent. So I think they're just trying to slow it down to a reasonable pace."
"Are they going to make mistakes, like figuring out the circuit breakers and making them too tight? Absolutely. That's going to cause volatility. They just have to make this transition, and not be quite so dependent on investment and manufacturing. That's what they're trying to do. It's going to be fits and starts, it will cause volatility, but we believe they will get it done."
When asked about oil, Mr. Buchanan said, "It's tough to say near-term where oil is going."
"You don't want to have an investment theme that's predicated on trying to anticipate an inflection point in the price of oil. We strongly believe – and we think it's a 2016 event – we're going to print the bottom on oil, and that you will see a migration higher in terms of pricing."
"When you factor in all the costs – whether seismic or drilling, all that goes into developing a new well – they're well above the current price. It's just a matter of time before you start to see production come down in a meaningful way. At the same time, we do see demand continuing to grow. That supply-demand dynamic should go a ways towards addressing the imbalance."
"There's a number of companies right now where you can get outsized yield, and outsized potential for capital appreciation," Mr. Buchanan said. "Our models are telling us what's being priced in right now is about a 60 percent implied default rate over a five-year period for the energy sector. In other words, over a five-year timeframe, the market is pricing in more than one out of every two companies going out of business. We certainly recognize their stress, but we think that is much more severe than what will ultimately transpire. Therein lies the opportunity."
"Mike does a great job of explaining the dynamics," Mr. Glasser observed. "Three or four months ago, we were on a panel together out in California. I said I found much more value in energy fixed income than I did in energy equities. And I continue to believe that."
"There's too much money out there. All this easy financing continues to finance – at least for the moment – marginal players in the energy field. That money needs to dry up before you get a true reduction, and that's going to take time. I also think there's a big disparity between some of the higher quality energy companies and the lower tier. That's best played through fixed income."
"Ultimately energy prices need to be much higher, but it's going to take time," Mr. Glasser said.
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