Last year’s equity market fall was overdue and healthy for the future
Last year’s fall in equity markets was long overdue and, in my view, very healthy for future prospects. It is not normal for equity markets to rise for nine consecutive years – even in multi-year bull markets one would usually experience the odd negative year and a more mixed pattern of up and down years.
This long run of gains can only be deemed the consequence of the extraordinary money-printing exercise conducted in recent years by the world’s central banks.
The year this went into reverse, with the US Federal Reserve raising interest rates consistently and reducing the size of its balance sheet, risk assets fell.
The first casualties of tighter liquidity – and a stronger dollar – were emerging markets, but the rolling bear wave moved into developed markets via Europe, credit and eventually US equities and their cheerleaders the so-called Faang (Facebook, Apple, Amazon, Netflix and Google) stocks. As interest rates on US cash reached levels which at long last provided a genuine alternative investment to bonds and equities, falls in equities accelerated into the year end and investor sentiment plummeted.
While economic data was deteriorating throughout the setback – notably in purchasing managers’ indices – and the yield curve very nearly inverted, raising fears of an imminent recession, for the most part the fall was a de-rating of equities rather than being the result of significant downgrades to profit expectations.
For sure, the momentum of US profits growth has clearly peaked with the tax-cut-induced boost to earnings in 2018, but as the US economy returns to trend rates of growth, profits should still rise, albeit much more modestly.
Many shares have fallen a very long way. Declines of 25 per cent to 40 per cent or more from their 12-month highs were widespread.
Given the extent of the falls and the degree to which sentiment moved to levels of extreme bearishness – in a complete reversal of last January’s euphoric talk of a “melt-up” in markets – it was clear that it would not take much to see a swift and significant bounce.
Right on cue, there was better news on several sources of concern. The Fed completely changed its rhetoric on both further interest rate rises and its balance sheet reduction programme. Bond markets immediately removed any expectation of further rises this year, and there are some forecasts of an easing instead.
The US and China made much more constructive noises about their trade negotiations, lessening fears of a trade war, while China fed us a diet of modest stimulus and credit easing measures, designed to support its slowing economy. Meanwhile, closer to home, after pre-Christmas warnings from retailers of dire trading in November, there was relief that December proved better.
No wonder markets raced to make good some of their previous losses. And so swift and sizeable have been the gains that one suspects precious few hoovered up shares at bargain prices and were positioned for the rally. Short term, some retracement is almost inevitable. But is this a sucker’s rally one should sell or should you buy any dips?
Much will depend on the data, as the Fed has made clear, that will determine its policy stance. Credit markets had tightened to levels that could create some difficulties in companies’ refinancing debt in the bond market. Yet the US labour market remains buoyant, consumers will benefit from lower oil prices and mortgage financing is cheaper again. My take is that US rates are on hold for now, that the US expansion isn’t over yet and for all that we know we must be nearer the end of the cycle than the beginning, with no recession imminent. Provided China’s policy measures do indeed stabilise the current declining growth rate – admittedly a fairly material “if” – then over the coming months that too should help stabilise Europe, where the impact of weakness in China is clearly impacting German exporters.
But poor data may continue in Europe for some months yet, before any signs of improvement emerge.
Meanwhile, the only thing that can be said with any degree of certainty about Brexit is that the uncertainty about the outcome is having a negative effect on the UK economy, as business confidence and investment – and quite possibly consumer confidence – are affected.
For as long as the uncertainty persists this is acting as a form of handbrake on the UK economy, restricting our quarterly growth rate to 0.2-0.3 per cent rather than the 0.5 per cent rate to which I think we would return once a constructive outcome could be agreed.
My working assumption remains that it is in no one’s interest to see the UK fall out of the EU without some form of agreed deal, so eventually one will be hammered out. But this is pretty meagre material from which to build a bull case for UK equities – other than that valuations remain below their long-term averages.
If some form of Brexit can be agreed and the global economy continues as outlined, with no early downturn, then modest profits growth should enable equity markets to grind higher.
Readers are perfectly entitled to point out that there are a higher than usual number of “ifs” in this prognosis. But therein lies the opportunity…
Richard Buxton is manager of the Merian UK Alpha Fund, Merian Global Investors