All good things come to an end, but it is unlikely we will see a recession return any time soon
After the unreal calm of 2017, we have seen a pronounced increase in equity market volatility so far this year. Markets are trading at levels similar to those seen at the start of 2018, but this does not tell the whole story.
Investor sentiment has been riled by a series of negative shocks, presenting some good opportunities to buy the dips.
At the turn of the year, stocks were in melt up mode, as analysts factored in the consequences of President Trump’s astonishing late cycle tax cuts. Things took a turn for the worse in February and it has been fascinating to watch as the apparent rationale for this period of weakness has morphed.
At first, people said global growth was too strong and inflation was out of control, on the basis of a small uptick in a US hourly earnings series that has since reversed. The markets recovered somewhat, only to dive to new lows after Trump threatened a trade war. Since then, Facebook’s woes and increasing geopolitical tensions have also been cited as causes of weakness.
But none of this explains why markets were so calm throughout 2017 in the face of an avalanche of provocative presidential tweets, international incidents and natural disasters.
Economic growth provides the wherewithal for profits to grow and companies to pay dividends. When growth is strong, risk appetites tend to increase, leading investors to place a higher multiple on earnings. Stockmarkets respond to changes in growth more than anything else.
The growth picture in 2017 – at least outside the Brexit-stricken UK – was the best of all possible worlds. US growth was strong, with business confidence rising. Additional stimulus deployed ahead of the Party Congress meant China was also posting strong numbers. Continental Europe staged a remarkable, export-led recovery.
Trump could do or say pretty much what he liked and the market just would not stay down. Volatility dropped to a decade low.
However, cracks are starting to appear in this story of synchronised global growth. Economic data has begun to miss expectations, with Europe, in particular, showing widespread signs of deceleration, owing in a big part to the unwelcome euro strength over the past year.
It seems likely the market turbulence we have seen over the past few weeks marks a peak in global growth. Stocks are very good at picking up early signs of weakness and it is not until much later the consensus realises that growth was the problem.
Markets tend to trade sideways during the seasonally weak summer months. Since 1974, global equities have posted US dollar returns of around 10 per cent a year, but the May to October period has averaged at less than 1 per cent.
But while both this and the signs of a cooling off in growth point to a soggy summer, we do not believe the economic expansion or the associated equity bull market are over.
The US economy is experiencing a steady but very long expansion at present, uninterrupted since the global financial crisis and already the second longest since the 1840s. We are just a year shy of the 1990s boom.
If growth does cool off over the summer, this should not be seen as the start of a recession. What tends to kill economic expansion is runaway inflation, which forces central banks to hike rates. Core inflation is rising in the US but the impact of globalisation on product and labour markets, plus the ongoing technology revolution, will continue to limit its upside. Moreover, softer growth is likely to take some of the pressure out of the inflation situation.
Central banks have been looking for an excuse to raise rates to something approaching ‘normal’ levels, but with inflation low and growth apparently pausing, they should be very slow to increase the cost of money. The Chinese authorities are already easing policy. And sitting below the level of inflation, real interest rates are negative in every major economy, including the US. It would be surprising indeed if such a loose policy setting triggered anything other than a temporary setback in economic activity.
All good things come to an end. At some point we will see a recession but, at the moment, there is no evidence to suggest higher interest rates are causing hardship or credit stress.
In that context, bouts of market volatility provide opportunities for contrarian investors to buy when everyone loses faith, trimming back again when markets factor in all of the good news, all the while keeping one eye fixed on the longer-term picture.
Trevor Greetham is head of multi-asset at Royal London Asset Management