Market falls never feel pleasant, but for those with long-term investment horizons there is no need to panic. Fluctuations, sometimes significant ones, are to be expected during the course of investing; and for those requiring the assurance of no fall in capital the only asset class that can be considered is cash. This is the second period of increased volatility that we have faced this year following the February/March pull back. Reasons for this latest bout of volatility have been much discussed – and the focus has tended to be on global bond yields coupled with a rumbling, US-driven, trade war.
The global economic environment has been improving for a number of years, while inflation and interest rates have remained relatively low. Central banks have kept their monetary policy accommodative for a prolonged period, which helps support global asset prices. This backdrop has allowed companies to grow and their valuations to rise, while market volatility has been around record low levels for a very long time.
One of the triggers for recent corrections has, counterintuitively, been strong data and economic progress from the United States. This has led to expectations of faster interest rate rises in the country, which pushes bond yields up and prices down. A trade war and rising oil prices can also be considered to be both politically destabilising and inflationary. Comparing companies’ future earnings expectations with higher rates of inflation and borrowing costs can cause a selloff in shares. If your “risk free” asset is yielding more, then risky assets become less attractive to investors.
against the background of this more uncertain outlook, investors have required additional compensation to hold equities.
To sum up: against the background of this more uncertain outlook, investors have required additional compensation to hold equities. This is represented by a higher equity risk premia or lower earnings multiple, in essence a cheaper valuation. And this is something that we’ve seen happening this year.
This correction is a reminder that economies and markets can move in different directions, something that often gets forgotten. Strong economic data such as the current rate of US GDP growth is not always positive for investments. It depends on the implications of that data and what has already been taken into consideration. Although a strong economy, relatively supportive financial conditions and a gradual increase in interest rates back towards more “normal” levels would be seen by many as a favourable investment environment, it is evident from recent price action in the markets that the journey towards less accommodative central bank policy and higher interest rates may well be a bumpy one.
Financial conditions need to be tightened in a controlled manner to avoid derailing global economies and we are seeing a divergence between central banks which are managing economies at differing stages of the cycle. In the longer term, however, we remain confident that investors should be rewarded for holding a diversified, well-constructed portfolio of the appropriate risk level for their circumstances.
When the stock market is suddenly headline news, which it inevitably is during falls but rarely, it seems, during rises, taking a step back can be difficult. However, the right course of action is to decide whether anything has fundamentally changed in your investment rationale.
The current theme embraced by the equity bears is that the current, nine-year long, economic (and market) cycle is long in the tooth and therefore about to come to an end. We would argue that cycles don’t die of old age but end because of overheating – in essence, too much froth in the economy or too much exuberance in markets. It’s not obvious to us that the global economy is running too hot – inflation is generally at or below levels central banks would like to see; elsewhere, financial markets have not been imbued with the type of euphoria which is generally seen before a prolonged downturn.
We would argue, therefore, that there is scope to be optimistic on stock markets, particularly given lower valuations. However, we do need to remain vigilant and the two things we are keeping a close eye on are the outlook for corporate earnings and the stance of the major central banks, as a deterioration in the former or a more hawkish stance of the latter is likely to give the bears further gratification in the short term.
Panic selling into falling markets may exacerbate losses because if you intend to reinvest you may compound the problem by missing a bounce back up. It is often wise to be a spectator rather than a participant in trading at times of high volatility.
The above article was previously published by Charles Stanley on 25th October 2018