Investors are quite rightly nervous after sharp market falls in the final quarter of last year. However, that it’s not all doom and gloom. In fact, there are reasons to be positive.
Equities are discounting a recession that is unlikely to happen. Although growth is certainly slowing down, none of the world’s major countries are likely to see their economies contract this year. Corporate earnings are growing, albeit at a slower rate, and inflation looks under control. Following the sharp fall in equities at the end of last year, this should provide some reassurance for those with exposure to the stock market.
Recessions are usually caused by central banks. Policymakers often overreact at the peak of a cycle – and tighten financial conditions so much that a hard landing becomes inevitable. It was no co-incidence that global equity markets peaked last year on the same day that Federal Reserve Chair Jerome Powell said the central bank was “a long way” from getting rates to neutral. Both events happened on 3 October, 2018 and both are very much related.
“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore,” Mr Powell said, spooking the markets. “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral.”
Policymakers at the Federal Reserve were probably a little too obsessed with getting back to this neutral level. It is likely the size of the market reaction to his comments surprised Mr Powell – and the unprecedented criticism of the head of the Federal Reserve by President Trump was also likely to smart too. So, at the start of January, Mr Powell relaxed his position. He said that the central bank has the ability to be “patient” in determining when to hike interest rates. This view was repeated last week by Esther George, the President of Kansas City Fed and a voting member of the rate-setting Federal Open Market Committee. Significantly, she is also regarded as one of the most hawkish of the rate setters. “A pause in the normalisation process would give us time to assess if the economy is responding as expected with a slowing of growth to a pace that is sustainable over the longer run,” Mrs George said. “Failure to recognise these lags could lead to an overtightening of policy, a downturn in economic growth and an undershooting of our inflation objective.” This statement telegraphed to investors that even hawkish members of the FOMC are cautious that they could tighten too far too fast.
Investors have been dealing with the distortions introduced by monetary policy for a number of years. While the sharp reductions in interest rates were originally introduced to cushion the recession in 2007, they were retained long after the economy recovered and now seem to be a permanent part of the landscape. Central bankers are trying to reduce special measures such as quantitative easing – but it is likely to remain part of their toolkits.
This apparent change of position by the Federal Reserve has led some commentators in the US to claim the recent correction in equities ended with the torrid session on Christmas Eve. Indeed, markets have rallied significantly since then. The S&P 500 is up 11%, the DJIA is up 10% and the MSCI World Index is up 9% since December 24. Citigroup is also forecasting a 14% rise in global equites this year. Calling the end of the correction in such a manner is probably a mistake – there are plenty of potholes to overcome and there will be plenty of volatility ahead – but there are reasons to be positive too.
Currently, there are no signs of overheating in the real economy, evidenced by an unwelcome rise in inflation. There is also not much evidence of overheating in financial markets. Equities reached all-time highs last year, but it is by no means clear that financial markets were being fuelled by speculative excess. Cash holdings have been generally high, which is not a sign of excess. Indeed, the release last week of the latest fund manager survey by Bank of America Merrill Lynch indicated that cash held by fund managers has now risen to 4.9% of total assets. Respondents remain bearish on earnings and economic growth but were starting to get back into riskier assets. It showed that money managers had stopped their rotation into bonds from equites.
Corporate earnings are definitely going to grow at a lower level this year – but this was always going to be the case after the sugar rush of the Trump tax cuts last year, which spurred a frenzy of share buyback activity and boosted companies’ bottom lines. What is important is that they are still growing.
There is also a strong possibility that the trade war will come to some sort of resolution, hopefully before the end of the first quarter. This will remove a major drag on sentiment. Helpfully, China has announced a number of measures to boost its economy. Last week the country’s central bank injected around $85bn (£66.1bn) into the country’s banking system and it has cut reserve requirement for banks. This should hopefully show up in economic activity – and Chinese equities – over the next few months. Another positive is the fact that the Italian budget crisis has not escalated, as many had feared.
Market sentiment is clearly fragile, and market volatility is likely to remain elevated, particularly in the short term. However, the outlook for equities may not be as gloomy as many currently think.
The above article was previously published by Charles Stanley on 21st January 2019