Equity markets have had a tumultuous start to the year, with the FTSE 100 now more than 20 per cent down from its 2015 peak, placing it in bear market territory. Investors have struggled to hold their nerve, so fears of a market slump have become a self-fulfilling prophecy. Contrarian investors, however, have been able to take advantage of the turmoil.
The drivers of the falls we are seeing this year are different from those in 2015, and it is important to make the distinction. Last year, fears about a slowdown in emerging economies and oversupply in the commodities sector dragged down developed markets.
A huge amount of capacity had been added in China and other emerging markets following large investment in new mines and oil fields but it coincided with falling demand. Once capacity growth outstripped demand growth, commodity spot prices began to fall, pushing down the share prices of miners and oil producers, which are very significant for the UK market.
The volatility witnessed this year has been much more broad-based, with the heaviest selling occurring in economically geared sectors, including the commodity stocks that had been suffering for many months. The spectre of an emerging market slowdown is still haunting investors, with fears a spillover effect will threaten the recovery underway in the developed world.
Meanwhile, sovereign wealth funds, backed by oil revenues, have been under pressure and withdrawing capital from equity markets through passive vehicles, which has contributed to the wider sell-off.
But the market is overreacting. While there is strong evidence companies with high exposure to emerging markets have been hurt by last year’s events, there is very little to show confidence in developed markets has been hit. Readings from key economic indicators, such as the US Services PMI and employment data, remain strong and point to recovery.
US domestic stocks performed very strongly in 2015, as the market showed a preference for developed market earnings. Now, though, we are seeing indiscriminate selling and unwillingness to take on any form of risk.
Any stock geared into a growth environment has been sold off. This has created a valuation gap between defensive and cyclical companies, presenting opportunities for contrarian stock pickers such as myself. As many investors have sought the safety of large-cap defensive names (and have paid a premium for the privilege) I have been finding attractive ideas in the cyclical sectors of the UK market.
The indiscriminate nature of the sell-off has not only created new ideas but has enabled investors to top up on existing high conviction positions. I have used this period to add to names such as Citigroup, CRH and Wolseley.
Following the devaluation in sterling over the past few months as Brexit fears have intensified, these stocks offer the attraction of non-sterling revenues, as well as the positive change stories underway in their businesses.
Elsewhere, a number of more domestically oriented companies such as Royal Mail and Esure have issued positive trading updates, which have been largely overlooked by a sentiment-driven market, so we have topped up some of these names.
Tobacco, healthcare and utilities stocks are trading on high valuations but if you want to own stocks more geared into the performance of the economy, such as the unloved banks and oil producers, you can now buy them at knockdown prices.
We feel comfortable in the oil sector because we see some of the supply now coming out of the market. Around 10 per cent of the fund is in oil, mostly in BG and Shell. Shell is paying a dividend of around 7 per cent and the market does not think this is sustainable. We disagree, however, so to us the stock looks cheap.
In the banking sector, shares are trading at 2011 levels, which tells us the market is being driven largely by emotion and is pricing in a grim scenario caused by one very specific part of the global economy.
Within banks, Lloyds remains in our top 10 holdings as it has a high market share in stable areas of the banking industry such as the mortgage market, and we expect it to be able to finance its dividend from its high quality underlying business.
Looking forward, while we think there may be more pain to come in those commodity sectors unable to address their supply/demand imbalances, the outlook for the equity market more generally is one of selective opportunity. Good news for the contrarians among us.
Alex Wright is manager of the Fidelity Special Situations fund