Global equities were shaken in early February by higher than expected inflation data and rising market interest rates. After a largely straight run for over a year, exceptionally low levels of volatility suggested markets had become too complacent and consolidation was overdue. However, the speed and magnitude of the adjustment caught investors by surprise and, although this has been explained away by technical factors associated with quantitative based trading, it may indicate other subtle changes.
Major equity markets fell more or less in unison closing down at least 3.5% in local currency terms. Peak to trough this year, the US and UK declined 10% and 9% respectively before recovering towards month-end. The S&P 500 lost 108 points to close at 2,713, the FTSE 100 258 to 7,231 and the FTSEurofirst 300 57 to 1,487. The Nikkei 225 was hardest hit with a fall of 1,440 to 22,068. Lower starting valuations insulated Asian and emerging markets, where losses were less than 1%. Bond yields have been rising steadily this year, with US 10-year touching 2.94% before retreating to 2.86%, unchanged on the month. Demand from pension funds continues to suppress UK gilt yields, with the 10-year touching 1.65% but closing unchanged at 1.45%. Corporate bond spreads widened giving back January’s outperformance.
What has changed? Since the financial crisis, equity market corrections have usually been triggered by global growth scares but on this occasion the strong upturn in nominal GDP growth has led to tightening labour markets and fears that the era of negative real interest rates is ending as central banks abandon quantitative easing and raise interest rates. Although this is not new news, the cyclical upturn in the Eurozone and Japan means their central banks are on the cusp of policy change and will follow a similar path to the US and UK. While it may suggest the economic cycle has peaked and growth is unlikely to accelerate, this does not – in our view – mark the end.
Global economic activity is as strong as it has been for a decade with GDP growth estimated to be around 3.5% this year and next. Consumption continues to be the main driver but a cyclical upturn in US and Eurozone manufacturing has boosted trade and industrial production elsewhere. The recent sharp upturn in US imports, strong consumer and business confidence and approval of the US fiscal package pave the way for increased corporate investment. The momentum will inevitably slow in the coming months, not least because of policy action in China. Having exceeded expectations in 2016/17, Chinese growth will ease this year as the National People’s Congress tightens monetary policy to reduce lending and financial risks. The impact of deleveraging is likely to be seen across the economy, from infrastructure to consumer and non-consumer loans. Estimated GDP growth of 6.5% is still very strong – and well above the 4.8% average for emerging economies – but the deceleration from close to 7% could have repercussions for the global economy.
Closer to home, UK companies are benefiting from strong export growth and sterling weakness, which should help the economy maintain modest GDP growth of around 1.6% this year. The squeeze on households and real wages is expected to ease but uncertainty about future trade arrangements will continue to impact corporate investment. Despite the politics around the Brexit negotiations becoming increasingly noisy, the most likely outcome is a transition period for existing trade arrangements and limited EU voting rights until December 2020. The risk of a chaotic Brexit in March 2019 and/or a general election remains low.
Trade pressures have been building for some time – largely as a result of the US administration’s determination to make “America great again”. The US Trade Policy presented to Congress in late February was in line with expectations and the fallout should be limited despite short-term political positioning. The basic principle is aligning US economic security with national security and strengthening the former by deregulation and tax reform. While there is little evidence that protectionism works for long periods, existing US trade laws are being aggressively enforced in areas such as solar panels and washing machines, and President Trump has announced an investigation into steel and aluminium imports. China could well retaliate on soybeans and the EU on motorcycles, bourbon and agricultural products.
The timing of these trade frictions is unhelpful when financial markets are becoming increasingly nervous about global inflation. Even though this remains exceptionally low, tight labour markets and Brent crude above $65 are causing concern. One trigger for last month’s equity falls was higher than expected US wage growth, which could hit over 3% in the coming months. This has not been inflationary so far although, with job creation still exceeding the replacement rate, US unemployment is expected to fall to 3.6% by year-end and tighten the labour market further. If productivity also improves, the pass through from wage rises may be limited but the strength of the economy gives the Federal Reserve an opportunity to continue normalising interest rates. Rising core CPI towards the 2% target later this year, the fiscal impulse from tax cuts and higher Treasury issuance all support the new Governor’s hint that “gradual” could mean four rather than three rises in 2018, taking rates from 1.5% to 2.5%. Despite modest UK growth, the Bank of England may also be nudging rate expectations higher with the Deputy Governor commenting recently that two rises this year would not be a surprise.
As equity market drawdowns are a common occurrence, we are not overly concerned by recent developments. With the economic and monetary backdrop remaining favourable for corporate profitability, equities should produce better returns than bonds over the foreseeable future. Upward earnings revisions during the year-end results season mean markets may pause for breath until companies deliver on their optimistic guidance. Meanwhile, robust dividends and increased merger and acquisition activity should provide a floor. At this stage in the cycle when strong GDP growth, rising inflation and higher bond yields would normally see rotation from growth to value/cyclicals, sector performance has not been quite as expected. The threat of trade tariffs has weighed on some cyclical sectors – including mining and autos – although banks have benefited from their continuing rehabilitation and the prospect of higher interest rates. Some growth sectors have held up well – notably technology, where valuations are high but appear well supported by earnings and return on equity. Consumer staples, healthcare, telecoms and utilities are facing challenges as well as earnings downgrades.
