Buying opportunity or wait for the dust to settle?

Investors should not attempt to catch the proverbial falling knife in reaction to plummeting global equity markets, says Dominic Rossi, global chief investment officer for Fidelity Worldwide.

Speaking as developed markets in Europe and the US approached losses of 5% following the 8.5% fall in Chinese stockmarkets, in what has been dubbed China's Black Monday, Rossi urges investors to wait for some clarity on official policy response to the crisis before putting their buying boots on.

Currency markets are reflecting expectations that the US Federal Reserve and the Bank of England (BoE) will need to now reassess the timing of mooted rate rises. Until last week, investors had been expecting the US to begin raising interest rates as early as next month and for the BoE to follow by the January 2016. Today, the euro and the yen have both soared against the dollar and sterling as traders digest the implications of the crisis in emerging markets, betting that the US and UK will be forced to hold fire.

Rossi has dubbed this crisis the third wave of deflation. The first wave was the US-led housing and financial crisis of 2008-09; the second was the eurozone crisis in 2011-12. The emerging markets and commodities crisis is the third wave, and although hallmarks are similar to the 1997-98 Asian currency crisis, Rossi is among market-watchers and investors who do not believe this crisis will turn out as badly.

Nevertheless, Rossi does not see any reason to jump back in to equities right now. However, he does believe the China-inspired disinflationary shock to the global economy will mean that investors will continue to live in a world of relatively high equity valuations, but low rates of return that reflect a lower real and nominal rate of growth in the global economy.

To escape this "humdrum environment", Rossi says Fidelity suggests avoiding companies that are highly leveraged and focusing instead on companies that can demonstrate excess return on cashflow. However he also believes the excess stockmarket returns will continue to be driven by innovative companies, particularly those in the technology, healthcare and media sectors; and that when markets do regain their poise investors should favour the "leadership qualities" of the US and the UK markets.

Mike McCudden, head of derivatives at Interactive Investor, agrees and says "the Great Fall of China" does not represent a buying opportunity. "Just because everything currently looks cheap should not be used as an excuse to buy and investors may be well advised to wait for the dust to settle before entering the fray." He adds: "Obviously, the next move from the central banks of China and the US will be key and in the short term we could see a significant bounce. However, the lack of transparency displayed from the world's second largest economy looks set to fuel the fire of volatility for the foreseeable future."

At Tilney BestInvest, chief investment officer Gareth Lewis argues that the speed and magnitude of the fall in equity prices shows that support for the recent leg of the long bull market was fairly weak. "I think it's safe to say the current structure of risk asset valuations had become an artificial construct created largely by central bank policy measures. With this failing to create a sustainable economic recovery, investors are right to be nervous about what happens next."

Lewis adds that market valuations will quickly get to fair value, "but the unwind of leverage and shifting liquidity suggests markets could undershoot".

Buying opportunity?

While Interactive Investor and Fidelity urge caution, and to only consider buying equities slowly and selectively until the volatility subsides, strategists at Royal London Investment Management reckon this could be one of the strongest contrarian buying opportunities on record.

Trevor Greetham, head of multi-asset at RLAM, says: "Our composite investor sentiment indicator has signalled one of the strongest contrarian buy signals on record with a depressed reading comparable with the onset of the great financial crisis in 2007, the Lehman failure in 2008 and the worst point of the euro crisis in 2011. This suggests a strong bounce, especially if we get policy shifts to turn market sentiment around. China will ease further, including on the fiscal side. Japan is likely to step up monetary ease in response to yen strength. Meanwhile policy will end up looser than expected in the US and Europe."

Greetham is very cautious of prospects for emerging markets, but already believes there is value to be found in developing markets. "We remain positive on equities and we are buying the dip on Wall Street," he says. "We see great similarities with the Asia crisis of the 1990s with the US generally on a path to monetary tightening but with Asia slowing, this time led by China not Japan. There were many shocks along the way over that decade as emerging market equities and commodities bore the brunt of the deflationary forces but US equities returned 400% over the period as a whole."

Over at Capital Economics, chief market economist John Higgins reckons that the market turmoil will not deter the US Federal Reserve from raising rates in September. However, Fidelity's Rossi is adamant that the Fed must soon recognise that deflation is coming its way in the form of a price shock and that the world is not facing any inflationary pressures over the next 12 months.

But Capital Economics is sticking with its year-end forecasts for major markets: "It has been our long-held view that the S&P 500 would struggle to make more headway this year and beyond, as the strength of the labour market and until recently the dollar began to squeeze margins," says Higgins. "As such, our end-2015 forecast of 2,100 for the index, to which we are sticking, remains less than 10% above its level now. We also continue to forecast that the S&P 500 will grind only slowly higher to 2,200 in 2016 - an increase from today of about 14% or so."

On Germany, the UK and Japan, Higgins thinks there is plenty of upside for investors to chase over the coming year. "The performance of these stockmarkets relative to that of the S&P 500 has tended this year to coincide with swings in the value of the dollar against the euro, sterling and the yen, respectively," he says. "With this in mind, we expect all three indices to fare better than the S&P 500 again if, and when, the dollar bounces back.

"By the end of 2016, we are forecasting the biggest gain in the Dax 30 (nearly 35% to 13,000), followed by the Nikkei 225 and the FTSE 100 (more than 20% each, to 23,000 and 7,250, respectively)."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.