Markets in turmoil – our view
This week’s market turmoil, like in February and March, started as a technical correction after six months of straight-up markets which required a little breathing space. Soon thereafter, however, fundamental concerns have crept in; while the trade war agenda has never gone away, the market has quickly switched its focus to US long-term yields rising to 3.25% (having spent the last few months fretting that the yield curve would invert because short-term rates were rising faster than long-term rates). In addition, inflation seems to be a top worry again with the Federal Reserve’s (Fed) actions under scrutiny. More fundamentally, there are some sectors worrying markets, such as US housing, autos, semi-conductors, tech in general and even luxury products.
Our first comment on the above is that the list is too long! When markets worry about too many things, it is a psychological rather than fundamental concern. Contrast 2011 and 2015. In 2011, markets had a laundry list of concerns: eurozone break-up, Chinese hard landing and US recession. After a couple of months, markets realised that, at least two of these three issues were bogus and recovered without any policy intervention. In 2015, there was only one concern: China devaluing the renminbi, which spread like wildfire through commodities and equities alike and did require policy action, specifically Chinese fiscal stimulus. The market correction was much longer (August to February).
What is striking is how contradictory a lot of these concerns are: yield curve inversion vs. the rise in long-term yields, slowdown in a few sectors vs. overheating, a strong dollar hurting emerging markets (EM) vs. domestic US inflation. It should be either one or the other. The most unloved bull market continues as such, with more expected episodes of volatility as Fed rates move higher. Let’s take these issues one by one.
- The Fed is hiking interest rates and money conditions are tightening, but (1) bank lending standards are easing, (2) money velocity* has turned up, (3) companies are accelerating their capital expenditure and (4) productivity looks like it’s recovering. The idea that Fed interest rates at 3% or even 3.5% should cause a recession is exaggerated based on other cycles. It is only President Trump who can call the Fed ‘crazy’ for having 2% interest rates! The 2004-2005 cycle saw more and faster rate rises to a higher level (5.25%) and did eventually cause a recession through the housing market.
- US housing and autos are topping, but that doesn’t mean they are about to go into reverse. The housing market is hitting affordability limits with 5%+ mortgages and autos are heavily influenced by the trade agenda.
- Trade wars are the wild card, no doubt, but even if tariffs stay for good, the best estimate is a 0.2-0.3% reduction in US growth and 0.5% in China, neither sufficient to turn the cycle into reverse. More importantly, Trump has agreed with Mexico and Canada and is trying to agree with the EU in order to focus all his efforts on China in what will increasingly look like a superpower cold war. It therefore appears that this is not going to be a global trade war with secondary effects. Other, more US-compliant countries (Vietnam, Korea) will pick up the slack from China and global growth may be redistributed rather than curtailed. It is, however, the biggest risk for markets and obviously one we will be monitoring very closely.
- It is interesting that markets are focusing on bonds falling together with stocks. If the concern is higher inflation, it makes sense that both asset classes should suffer, but then again, this means that the concern about the economy softening is overdone. Inflation is still very well behaved. On the basis of every reasonable price gauge, so far inflation fears have been unfounded. It generally takes 4%+ wage growth to feed into inflation. We’re very far from that level, although, here again, wages are one of the gauges we will be monitoring for any signs of impending inflationary pressure.
- Bond yields soaring have spooked the market (and then falling yields spooked them again – same inconsistency story). When the US 10-year yield breached 3%, it took four times to breach it again before it could stabilise above that level. The same could well happen with the 3.25% which we hit but did not breach. In contagion terms, if you look at the 10-year yield in January, its sharp rise was probably behind the February-March correction and the recent rise to 3.25% has probably also been behind the current correction.
- EM, Japan, Europe and tech are simply more volatile versions of the S&P. EM are still under the cosh due to trade war fears and debt levels in certain countries. They will take longer to bounce back, but Japan may be a little faster on the starting block once markets recover.
- A few self-correcting mechanisms are starting to show through too: (1) Inflation in EM has been exacerbated by oil prices; they are now falling. (2) EM are also hurt by a strong dollar; it is now softer. (3) Spiking bond yields are damaging equities; they are now lower. (4) Housing and autos sectors are slowing the US economy; the Fed will take heed. Corrections can take care of themselves when there isn’t a fundamental issue. The US corporate earnings season is upon us and may actually help markets feel more sanguine about future prospects.
One last comment. Don’t forget the US midterm elections on 6 November. They always cause volatility and this time perhaps more due to the publicity that President Trump is affording them. It is difficult to see how markets can recover durably before that deadline, although the speed of the initial drop could indicate a quicker bottoming process. The outcome of the midterms is unlikely to spook the markets, other than if you have a total sweep by one party: Republicans could action another massive tax cut and Democrats could exercise a US$1trn infrastructure spend. Either way, the Fed would react. Somewhere in the middle, markets are likely to brush it off. In conclusion, the current correction should be seen as an opportunity for investors sitting on excess cash, not a threat.
*Money velocity is the speed at which money moves around the economy. Higher the velocity means greater economic expansion.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.