Profit as global markets panic

MoneyWeek magazine cover illustrationAn oil slump and the crashing rouble are hammering markets – now’s the time to pick up bargains, say John Stepek and Andrew Van Sickle.

December is usually a great month for the UK stockmarket. In fact, on average, it’s the best month of the year. As Laith Khalaf of Hargreaves Lansdown points out, since 1984, December has been a winning month for UK stocks 87% of the time, with an average gain of 2.6%. It’s not clear why this phenomenon exists – a fluke, seasonal good cheer boosting investor optimism, or end-of-year performance-chasing by lagging fund managers.

But what is clear is this: unless there’s a rampant recovery in the few trading days before the new year, this year’s Santa Claus rally has been cancelled. Earlier this week, the FTSE 100 hit the lowest level seen this year, down nearly 10% from its high – that’s going almost into “correction” territory (10% is a correction, 20% a bear market, according to the semi-official definitions). And it’s far from alone – global stockmarkets had a rough week.

What’s the problem? First, there’s the stunning slide in oil prices. Secondly, there’s the growing currency crisis in Russia. These two things are intimately connected – in addition, the danger and the worry is that both the crashing oil price and the crashing rouble will have far-reaching effects on the wider markets.

Turning to oil first – the price of Brent crude is down by 40% since June, and is now at a five-and-a-half year low of below $60 a barrel. “The story for crude remains the same,” as Yousef Abbasi of Jones Trading put it. “Slower global growth, excess supply, and an unwillingness of Opec and others to cut production as they vie for market share.”

It’s an oil-price war, effectively. As a result of the tumbling price, stockmarkets skewed towards the oil and gas sector have suffered the most – hence the bad month for the FTSE 100. The sector makes up 15% of the FTSE, compared to just 8% for the S&P 500 in America. Emerging markets – which tend to suffer both when the US dollar is rising and when commodity prices are falling – are at a five-year low.

What’s worrying investors in global markets?

Why are investors so rattled by this? After all, falling oil prices are surely good – or at least neutral – news. Cheaper oil might be bad news for oil and gas producers, but it should represent a net benefit for the global economy. There are more oil consumers than producers, so falling oil prices cut costs for most businesses, allowing consumers to spend more.

We should “rejoice”, as David Smith puts it in The Sunday Times. According to Oxford Economics, every $20 fall in the price of crude bolsters global growth by 0.3% to 0.4%. In 2015 and 2016, forecasts (for what they’re worth) suggest that GDP will grow by an average of 2.6% a year if oil averages $84 a barrel. But if it falls to $40, the GDP growth estimate rises to 3%.

In the UK, despite our heavily taxed fuel, the price of a litre of petrol has fallen by 11p since June. By the time the full 40% drop in oil prices feeds through, “consumers will be benefiting from the equivalent of a tax cut of £10bn to £15bn – much more than in any modern budget”.

In the US, meanwhile, consumer confidence has hit an eight-year high and healthy recent retail sales suggest that consumers are enjoying their oil-induced tax break. But if lower oil prices are bullish long term, why the upheaval in markets?

It’s not about fear of a global slowdown, as some have suggested. Yes, some of the recent global economic data has been mixed, but certainly “not bad enough to generate such a sell-off”, says The Economist’s Buttonwood blog.

The likeliest answer is that “investors are simply startled by the sheer speed of the fall in oil… someone somewhere is losing a shedload of money”.

However, the very real danger is that this could be quite likely to lead to a domino effect, as losses in one area of the market lead to indiscriminate sales of other assets. “Like the rustle in the bushes that may be a tiger, investors figure it’s better to run away first and assess the situation from a safe distance.”

“When the market moves fast, stuff blows up,” agrees Jared Dillian of Mauldin Economics. Why? Because “people get used to regimes”. Oil has been going up for years, and until this year, $100 a barrel was seen by many as a “floor” for the price.

That means a lot of people have almost certainly made investments and trades that depend on oil prices being high. As a result, no matter how positive a falling oil price is in the long run, the potential for nasty surprises in the short run is high.

And it’s often “not the stuff you thought would blow up”; witness the unexpected bankruptcy of Orange County, California in 1994, for instance, when interest rates jumped. There could be an unexpected and important big bankruptcy lurking out there.

The Russian collapse

So far, the most obvious casualty of oil’s plunge is Russia. Oil and gas account for 70% of Russian exports and half of government revenues. So the oil price slump has hammered the economy.

Meanwhile, Western sanctions against the country following its annexation of Crimea have made it almost impossible for many companies to raise money from foreign investors. So even though the Russian state has plenty of money left over from the oil boom, “this time the crisis is in foreign dollar debt and the unwillingness of foreigners to fund it”, as Lex puts it in the FT. For example, $120bn-worth of Russian corporate dollar debt is due to be paid back next year.

Given the close links that many of the biggest companies have with the government, the state may step in to help out. But investors shouldn’t take that as a green light to pile in – as Lex notes, “such a pseudo-bail-out might sound good to minority investors, but [if] the state… provides the dollars, [it] is sure to demand much in return”.

With the economic outlook grim and the geopolitical situation tense, the Russian currency has taken a hammering. At the start of this year, US$1 would have bought you around 32 Russian roubles. At the end of last month, it would have bought just under 50. But this week, as the oil plunge worsened, the rouble hit an all-time low against the dollar.

On Tuesday, the Russian Central Bank tried to arrest the decline by hiking interest rates by 6.5 percentage points to 17%. However, its efforts merely rattled investors even further and the currency continued to plunge, diving as low as 80 to the dollar at one point.

As Larry Elliott put it in The Guardian, “Russia has spent the past nine months fighting an economic war against the West – and Tuesday, 16 December was the day that war was lost”.

What happens next? In terms of best-case scenarios, a jump in the oil price would help matters. A move to ease tensions over Ukraine would also be good news, as it would in turn allow the West to relax sanctions.

Of course, things can get much worse on both of these fronts too. The oil price could easily continue falling – and certainly by mid-week had shown no sign of stopping its decline – while a rattled Vladimir Putin might decide that escalating the conflict in Ukraine is the best way to keep an unnerved population on his side.

Neil Shearing of Capital Economics runs through three main scenarios – where the rouble continues to weaken; where it stabilises at around 65 roubles to the dollar; or where it rallies.

Even under the most positive scenario – where the rouble strengthens again and perhaps sanctions are lifted – inflation remains at around 12% to 15% until the second half of next year, which means that interest rates have to stay high too. However, Russia will still suffer a recession and it’s not until 2016 that a potential recovery seems likely.

As for the “bad news” scenarios – if the rouble keeps plunging, the authorities could be forced into drastic action. Capital controls could be imposed – preventing foreign investors from getting their money out without paying significant taxes, if at all, for example. Interest rates could end up going above 20%, as inflation surges.

And while the currency crashes there could easily be runs on local banks as rouble deposits are turned into dollars, while companies with foreign debt could “come under pressure triggering a string of private sector defaults and possible financial crisis”. In short, as Shearing puts it, “the key point is that there are no benign scenarios”.

So investing in Russia right now is a punt based on your view of how bad things could get politically, rather than a sensible value investment. It’s like “catching a falling knife” –you might get lucky and call the bottom, but you might also get your fingers chopped off.

And if the worst-case scenario comes true, there could be other worries than whether Russia is a buying opportunity or not. So where should you invest?

The six trusts to buy now

Investors have a ‘glass half-full’ dilemma here. On the one hand, a falling oil price is good news for the global economy. On the other, it may well have knock-on effects – perhaps drastic ones, depending on what happens to Russia – in financial markets that undermine that benefit. So what can you do?

The good news is that when markets sell off in a panic, it presents opportunities to pick up decent-quality investments at lower prices. And that’s why we think that – if you haven’t done so already – it might be a good time to allocate some of your money to our MoneyWeek investment trust portfolio, which has done well this year.

In the year to date (15 December to be precise), the portfolio is up by 13.1%, with dividends reinvested, compared to a drop of 4.6% for the FTSE All-Share, and a rise of 8.1% for the MSCI World index (in sterling terms, with dividends reinvested). That’s a pretty creditable performance for a portfolio that broadly aims for “absolute returns” – ie, beating inflation.

The portfolio contains six investment trusts. It’s split between trusts that work well in bear markets, and those that should benefit during bull markets – it’s designed to be an all-weather portfolio.

So if this turns out to be a storm in a teacup, you’ll get the benefit of the recovery. If it’s the start of a much more brutal downturn, you’ll get the protection from the more defensive trusts.

As our panel of experts (Sandy Cross of Rossie House, Alan Brierley of Canaccord Genuity, and Simon Elliott of Winterflood) puts it: “The trusts we have suggested are all intended to be long-term holdings; however, recent short-term performance would back up the notion that having some defensive exposure (eg, Personal Assets) and a bit of patience remains a good idea. The trusts in the portfolio aim for long-term growth and don’t simply mirror indices, and we see this as a strength”.

The six trusts are listed below, along with the premium or discount (whether they trade above or below net asset value – the portfolio’s underlying value) and the forward dividend yield.

Trust Ticker Prem/Disc Fwd yield
Caledonia Inv. CLDN -17.2% 2.2%
Personal Assets PNL 1.7% 1.6%
Scottish Mortg. SMT -0.9% 1.2%
Finsbury Growth FGT 2.2% 2.2%
RIT Capital RCP -5.9% 2.1%
3i Infrastructure 3IN 19.9% 4.4%