There have been plenty of bumps in financial markets over the past few months and, even with recent rallies, many portfolios show flat or negative returns since the start of the year.
Understandably, investors have started to question whether the core assumptions that have guided their portfolios in the past few years will continue to hold in the future.
It is not time for a fundamental rethink quite yet but there are some key questions hanging over the markets.
The first is whether China and emerging markets will sink the global recovery. Emerging economies are faced with three big challenges: slowing domestic demand; flat or falling world trade; and declining commodity prices.
Some countries are in a stronger position to cope with these difficulties than others. For China, the situation is especially mixed, with the traditional, industrial side of the economy in hard landing territory but the increasingly important services sector showing more resilience.
Should we worry this trouble will spill over into developed markets? Troubles in emerging markets will pull down global growth and inflation, and make life more complicated for the US central bank, but they should not derail the moderate economic recovery underway in the developed world.
The second question is whether recent market falls mark a temporary correction or the start of a full-blown bear market. Corrections are normal and happen most years in equity markets. It is partly to compensate for these market bumps that equities earn higher long-term returns. Historically, it has taken either a recession or extreme market valuations to trigger a true bear market, where equity prices fall by more than 20 per cent.
Though the picture is weaker than it was a few months ago, we do not see the ingredients for a recession in the developed world in the near future. A recession caused by excessive central bank tightening or a big rise in commodity prices seems particularly unlikely, given recent falls in inflation and commodity markets. Nor do we think extreme valuations are about to cause a problem – rather the opposite, given recent sell-offs. Standard valuation measures suggest the US, UK and Europe are all close to their long-term average values. The S&P 500 is a little below it.
The third question is whether the US Federal Reserve or the Bank of England will ever raise interest rates. The Fed likes to think it is being communicative. However, that backfired in September when it held off raising rates and communicated a lot of confusion about how it would decide policy going forward.
Senior Fed policymakers have continued to speak of a rate rise by the end of the year but they have found plenty of reasons to delay in the past. There is no guarantee they will not find more, especially with a build-up in inventories raising warning signs about the short-term strength of US demand.
If the recovery in the US and Europe continues to look decent, we would expect the US and UK central banks to raise rates within the next six months – much earlier than the market currently predicts.
However, it is the pace of rate increases and the long-term “neutral” policy rate that are much more important to investors than the exact date of the first tightening move. Both are likely to be much lower than in past cycles.
And I am sorry to say the same message probably applies to future investor returns. Though we do not expect a full-blown bear market in the near future, we have reached the stage in the cycle when returns are likely to be lower and to come with larger amounts of volatility.
That is especially true in a world that – for all the progress we have seen – is still struggling to deliver “normal” rates of growth and is finding it even more difficult to generate inflation.
Stephanie Flanders is chief market strategist for Europe at J.P. Morgan Asset Management