Economic Outlook for April
Just three days into the tenure of Jerome Powell as the new chairman of the US Federal Reserve, global equity markets experienced a 10% sell-off. An auspicious start some might say. Since 2008, bouts of equity market selling have been met with positive price support from central banks in the form of quantitative easing and record low interest rates. Unlike his predecessors, in the face of an equity market sell-off, Mr Powell has re-iterated guidance for continued rate rises through 2018 and beyond. By indicating that the Federal Reserve will not step in to save the day if and when equity markets weaken further, an important signal has been sent to the equity market. Also important has been Powell’s attention to highlight the strong economic data in the United States.
The steady rise in rates and end to US central bank support is happening because the real economy is doing well. The fact that equity market performance is weakening in this environment tells us something important. Asset markets are undergoing a regime change, and investors should be aware of the implications of this change.
Steady interest rate rises driven by strengthening economic fundamentals is a good thing. It means the US economy and therefore by proxy, the global economy, is returning (slowly) to a more normalised economic environment more akin to the decades preceding the 2008-2009 financial crisis. This is a fundamental change in the interest rate and central bank policy environment. Following a decade of support for asset markets from zero-level interest rates and quantitative easing, the global economy is finally seeing a sustained acceleration in growth.
Normalising interest rates and central bank policy is a welcome sign for long-term investors. In the short-term, this change in environment is likely to support higher volatility in most major asset markets, including equity markets. We may even see further price corrections and tests of previous support levels for indices. It will be important for investors to remain focussed on underlying economic data and corporate earnings for guidance on long-term positioning within equities. As markets become more volatile, company and sector fundamentals will become increasingly important in determining share price performance.
This regime change in global markets supports a shift into active equity management with a focus on investing in companies with strong long-term growth fundamentals at attractive valuations. The previous market regime of easy money and central bank policy supported low volatility and positive share price moves in all stocks. This is now over. After years of passive investment returns beating active returns, we are now likely to see this relative performance reversed, with stronger active management performance for the foreseeable future. In this new market regime, investors should expect a bumpier ride but also expect greater relative performance from choosing the right strategy.
Equity Markets Whipsaw
In early February global equity markets saw the return of higher volatility and prices corrected down. The S&P 500 peak-to-trough decline was 10% in the space of two weeks. By mid-March, markets appeared to be in recovery mode with most equity indices rallying 8% from the February lows. Since then we have seen markets turn back to risk-off mode, with the S&P 500 index trading back down to the previous YTD low for 2018. Equity market volatility is certainly back and it is not going away any time soon.
Rising interest rates and a realisation among market participants that central bank policy support may not be there for the next market decline is likely to have had some impact on short-term equity prices. Negative news-flow linked to President Trump’s decision to pick a fight with China over trade policy may also have added pressure to stock prices. Earlier in the year tensions around North Korea were blamed for higher volatility. Looking through the competing views of what is causing the weaker period of equity market prices, it is clear that markets are looking for direction and negative news items on topics like international trade will likely continue to have a much greater price impact than investors have been used to in recent years.
It is likely these news-driven price movements will remain short-term in nature and not reflect any long-term price momentum.
It’s the Economy, Stupid
While equity markets twist and turn, the real global economy continues to power ahead. This is not as surprising as one might first think. For the past decade asset market prices have been disconnected from the real underlying economy, supported more by central bank policy than real GDP growth. As that policy support is slowly turned off, we should expect to see equity markets experience a period of uncertainty as the underlying driver of market performance changes.
The real economic and corporate earnings data is strong. Corporate earnings growth in H2 2017 has accelerated and indicates the stronger economic data we are seeing globally is feeding through into company profits. In the United States, industrial production hit +4.3% YoY in February, economic confidence indicators remain close to all-time highs and retail sales growth continues to expand at +4% YoY. Underlying data for China and Europe also continue to indicate underlying economic activity is strong and expectations for growth are high.
The fundamental economic data is telling us that the global economy is doing well, and all else being equal this is positive for stock prices. While the equity market is making its mind up, investors should remain calm and focussed on what the underlying data is telling us.
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