Economic & Stock Market Commentary – February 2018

Economic & Stock Market Outlook, February 2018

Stock markets fell sharply in late January after US wage inflation hit its highest level since 2009, triggering fears that the US Federal Reserve (Fed) will need to raise interest rates more rapidly than expected. The sell-off was exacerbated by the frothy level of investor bullishness. The severity of the downward move also suggests forced selling by risk parity funds and other leveraged investors, with the VIX index of US stock market volatility seeing its largest ever one-day increase.

To keep things in context, the sell off to date merely reverses part of the December/January rally in stocks. The world economy is growing strongly, corporate earnings are being upgraded, equity market valuations are less “toppy” and we have witnessed a total clearing out of investor bullishness. Various composite sentiment indicators are heading for the most negative reading since the China devaluation panic of summer 2015.

Whilst the recent downturn has been in contrast to the previous period of stable upward returns, corrections of this type are normal, and occur frequently in both upward and downward long-term trends. One of our responsibilities as investment managers is to stress test these types of events when constructing portfolios, to establish that the level of risk is appropriate to the objectives that we are aiming to achieve. The timing of a correction is often a surprise but the correction itself is expected.

Corrections often indicate a change in market expectations and understanding, which can be used to identify investment opportunities going forward and can also have a useful cleansing effect. This can be visualised as the outgoing tide levelling the sand, after a sunny day at the seaside. On this occasion it has been interesting to note that some assets, which have shown bubble like tendencies, have been hit hard with the obvious example of Bitcoin, which has fallen from a peak around $20,000 to under $10,000.

The current environment of economic strength emerged slowly from a period of intense anxiety in 2009 following the systemic failure of the global banking system. The path to recovery was created through dramatic action from central banks, cutting interest rates and printing trillions of dollars (or their equivalent in local currency) in order to reduce borrowing rates to historical lows. This provided cheap finance and liquidity to the entire global economy and was ultimately successful in restoring economic growth.

Within our previous updates we have discussed the interest rate cycle, which has been falling since the 1980s, representing a very long cycle length. In addition, we proposed that few investors had experience of a rising rate environment as most careers of investment professionals did not go back that far. Furthermore, we felt that the improvement in economic conditions suggested that this long-term cycle was changing and we were now entering an upward interest rate cycle, which would change the behavioural characteristics of many asset classes.

Whilst central banks are moving into a rate rising cycle we expect this to be a very slow and measured process. Given the significant efforts which have been made to drag the global economy out of the 2009 credit crisis, we believe that central banks will be anxious about choking off the economic recovery and therefore, inflation will be allowed to run over target rather than pursued aggressively, at least in the early years of the rate rising process.

Furthermore, the wage inflation which has caused the recent correction is actually preferable, in the medium and long term, to the alternative of stagnant wages. In order to continue an upward economic cycle it is important that wages rise in real terms in order to allow future consumption to rise. If wages do not rise faster than inflation, then consumer debt builds to the point that consumption falls dramatically and leads to a recessionary outcome.

It is our view that the current shakeout of asset prices is a useful and necessary event. The assets most at risk are those which have benefited from speculative interest or where the valuation is heavily dependent on a low interest rate environment. Growth stocks have benefitted considerably in the market rises and some of these stocks now look vulnerable.

Value orientated stocks have provided reasonable returns but have not generally kept up with their growth counterparts. These companies have mature and predictable business models and whilst their upside potential is more modest they tend to be driven favourably by economic growth and are not sensitive to the relatively modest interest rate rises which are now expected.

The selloff in stocks looks like an overreaction. We expect bouts of volatility to become more common now the Fed is moving towards a normalisation of interest rates but we expect stocks to recover over the coming weeks and months as the economy continues to expand. Rising interest rates are a challenge to the stock market but only a serious one once they are high enough to cause the economy to roll over into recession. With the Fed Funds rate still below core inflation, that could take quite a while.

In conclusion, whilst it is difficult to predict how long or how low a correction will go, we remain confident that global equity markets will continue in an upward cycle. The current market conditions provide an opportunity to increase equity positions with a bias towards companies linked to economic growth, which is expected to remain positive. The rate rising cycle will be gentle, but negative for fixed interest investments, which have a high degree of sensitivity and we have already limited our exposure to these areas.