Even if some calm has now returned, the market declines this week are perhaps a little more disconcerting than usual as they have occurred with no obvious trigger and followed an extended period of very low volatility. This makes the situation a little more uncertain, as specific triggers can often be analysed, quantified and discounted. There is therefore the danger of investors becoming fearful of the unknown - and risk averse - should the declines become more serious.
Despite this lack of a specific trigger, we have however highlighted in recent months the following combination of factors which seemed likely to challenge equity markets over coming quarters:
- Significantly above average valuations in developed markets.
- The expectation of tighter monetary policy from the US Federal Reserve.
- Tighter monetary policy in China.
- Doubts over the timing and ultimate size of Trump's policy initiatives.
- The lack of follow through from positive economic surprises into earnings forecasts.
All of these concerns remain valid today. If anything, the recent increase in inflationary pressure in the US, UK and Eurozone makes the risk of tighter monetary policy an even greater concern now compared to earlier. We also note the recent surge in inter-bank funding costs in China, only a week after the central bank tightened policy.
In terms of our views on equity market overvaluation, a recent survey indicated that institutional investors believed that developed markets were more overvalued than at any other time in the survey's history. The small comfort from this data point is possibly that overvaluation concerns are now a consensus view. However, we believe that investors' willingness to hold stocks at such high valuations is inextricably bound to the current low interest rate and low volatility environment, which may not persist.
The very modest 2% decline from the highs for developed markets in recent days clearly does not shift us from our cautious view on global equity markets. For example, the current price/book multiple for US non-financials remains close to 40% over its long-term average. We also cannot even assess with any precision, especially in the absence of a specific trigger, how far any declines might run. However, the question of whether a more significant market decline may occur is in our view less important than what investors should do if it does.
Recognition that it is almost as difficult to invest in a volatile and declining market as it is to sit out a rising one may be a useful starting point. Should the declines turn into something more significant, investors should remain dispassionate and be prepared to take the other side of trades where the seller's need for liquidity has become the predominant driver for a transaction.
The rise of passive investment vehicles such as ETFs and the corresponding decline in single-stock activity may create opportunities similar to those on the day after the UK's Brexit vote, when many stocks initially fell abruptly only to recover in following days. Clearly, such a scenario is some way from the present situation but we believe it is as well to be psychologically prepared. From a portfolio perspective, cash needs to be on hand to implement such a strategy - thus highlighting the inherent contradiction in the advice to always remain fully invested and to buy the dip.
Furthermore, our concerns in terms of medium-term returns on market indices have been much more focused on valuation issues rather than any bubble in economic activity. This overvaluation has been primarily driven by the determination of central banks, most notably the US Fed, to maintain interest rates at emergency low levels for much longer than in previous cycles.
On the other hand, real economic activity has in fact largely disappointed expectations in recent years, with perhaps the exception of the last six months in Europe and the UK. Therefore a stock market correction would by no means necessitate a reduction in world economic growth forecasts as severe as that seen in 2008-2009. Nor would it be followed with certainty by another banking crisis, although we accept debt metrics remain extended in the non-financial corporate and government sectors.
It would however be likely to lead to a temporary delay to the Fed's tightening policy, just as was seen post-1987. An upward shift in the rate of return demanded by equity investors would represent a tightening of overall financial conditions but, with offsetting monetary policy, may not be as disruptive to the real economy as some may fear.
It is notable that when Fed officials talk of financial instability they do not seem to be talking about a crash. The instability they refer to is the a priori risk of a crash. "Financial instability" appears in Fed-speak to be a synonym or code word for an asset bubble. Therefore by stating the need to avoid financial instability, Fed officials including Fed Chair Yellen have this year put markets on notice that further gains in asset prices may be viewed by policymakers as undesirable. This leaves US markets in particular with return outcomes skewed to the downside.
Given our earlier analysis, the recent uptick in volatility and modest equity market declines this week should not be a surprise. There is no change in our cautious outlook on global equity markets; in our view investors are being given a rather generous amount of time to re-position portfolios for a more challenging environment as we enter Q2.