An overdue health check for global markets

Markets have seen a pullback in the past few days. Let’s be clear - in the long span of financial history, this is not news. Yet in a world where the concept of a “correction” almost feels alien and where equities felt like an unstoppable one-way bet for a while, the normality of a setback can feel more painful. 

But what we have seen is perhaps the greatest sign of the true health in markets for a long time. The tech-fuelled rally in the US had long lost any sense of reality in its valuations, the prospect of inflation remaining low forever could not last, and we have a new and untested chair of the US Federal Reserve. It would be more worrying if markets didn’t react to all of this.

Even accounting for recent price action, US equities remain up by around 50% since early 2016. The current price action may feel unusual because we have become so used to a low volatility environment, with economic data having been consistently positive across the globe in 2017.

So where do we go from here?
Alan Greenspan, a former Fed chair, said last week that bond and equity markets were in a bubble. But there is little new in this. It doesn’t take a former Fed chair to tell you that bond markets are in a bubble when yields on two-year German bunds are trading below the European Central Banks’s deposit rate, or that equities are vulnerable to a pullback when they have been breaking decades-old records for the past several months.

Bubbles can possibly persist for a long time, and while we might see a resumption of the previous (tech-led) trend, it seems more likely that this pause for breath will lead to a reassessment of the market’s leadership.

What might derail this thesis? The new Fed chair, Jerome Powell, has the potential to misstep in more ways than one. As ever, the central bank head has to walk a tightrope between prudence and sentiment. Either overtightening or a delay in tightening that would suggest a loss in confidence could spook equity markets and lead to a further leg down.

However, markets will understand that the new Fed chair was chosen in part because of his soft stance on interest rate. The risk of interpreting his statements as concerningly dovish therefore seems low.

Powell also has more ammunition than just his dovish public statements for convincing investors that he is not about to dramatically raise rates. Average hourly earnings may have surprised to the upside in the US, but it’s not clear that this is a marked uptrend. A twelve-month moving average of the same series looks more muted, and other measures of wage growth, such as the employment cost index, also look lacklustre. This provides cover to those like Jerome Powell, who will likely argue for a gradual pace of rate rises, rather than a sharp tightening.  

There are weaknesses across various equity sectors, but none so large yet the market is likely to fall through them. My money remains on equities - but rotating (and buying on weakness) into “value” areas of the market that have lagged in the recent momentum-driven rally. I’d also be avoiding stocks where dividend yields aren’t backed up by strong free cash flow and a solid balance sheet - the search for yield hasn’t just inflated higher-yielding stocks, it has fundamentally altered the business models of some companies for the worse. This supports the case for active management at the latter stages of the cycle. Holding this course if and when volatility eases won’t seem easy - but at this stage of the cycle, keeping your head when others are losing theirs is important.        

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