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Volatility returns – but we are not overheating yet

 
Jon Cunliffe
Markets have been on a roller coaster, but we do not think this is the end of the bull market

The long overdue pick up in equity market volatility has returned with a vengeance in recent weeks. The initial selloff in equities in early February had much to do with fears of a much more aggressive monetary policy stance on the part of the US Federal Reserve following the release of economic data pointing to rising domestic inflation pressures. Whilst the Fed hiked its key policy rate in March, there has been little change in its earlier interest rate guidance as the earlier fears of higher inflation have largely been confounded by the more recent data releases.


Given our view that US inflation will rise modestly, we viewed the selloff as an overreaction and argued that the selloff would prove to be a buying opportunity. Stocks did rise, but the rally has proven to be disappointingly short lived. What has changed? The new dynamic in the market has two components.

The first centres around the US administration’s more aggressive stance on trade, with President Trump announcing tariffs on $50bn of imported goods from China in addition to investigating its use of US intellectual property and exploring the possibility of restricting Chinese investment in sensitive US technology. At the time of writing, the Chinese response to all this has been measured and, as a proportion of US and Chinese output, the sums involved are very modest. However, markets are fearful that there is the potential for a more troubling tit-for-tat escalation which affects business confidence and the hitherto positive relationship between economic growth, corporate earnings and equity market returns. The chart below highlights how critical the trade cycle is for corporate profits. The blue line tracks the outlook for global trade. As it rises, reflecting higher future trade volumes, then corporate profits, denoted by the red line, grow more rapidly. On the other hand, a deteriorating outlook for global trade tends to be a good predictor of weaker corporate profits.

The second factor to consider is the risk of a regulatory backlash against large US technology companies. The catalyst has been the well-publicised investigation into the use by Facebook of its users’ data, but there has been an additional announcement by the EU that it will impose a 3% tax on the global revenues of large technology companies to ensure that they are taxed at a level more consistent with traditional “bricks and mortar” businesses. Again, this fear need to be assessed in the context of the inexorable digitisation of daily life and the strong earnings and increasingly less demanding valuations of a number of technology giants.


What should investors do in the light of these developments? Well, they need to be considered as risk factors that could potentially derail an otherwise positive outlook.

By way of background, the last twelve months has seen the strongest and most synchronised global growth for seven years – aligned with the strongest corporate earnings delivery since 2011. Moreover, the earlier caution on the part of businesses and consumers which characterised the sluggish global growth we saw in the 2012-16 period has been replaced by a much more optimistic stance, evidenced by a significant pickup in business investment and consumer confidence. Taken together, these factors have been a tailwind for equity markets, with an additional positive the marked improvement in the prospects for much of the emerging world.

Elsewhere, despite fears of a rout as markets increasingly anticipate the end of easy central bank policy, the overall rise in global bond yields has been reasonably contained. This is important for equity investors as a key valuation metric remains the difference between the earnings yield on equities and the yield on bonds. This yield gap remains quite wide by historical standards and remains one of the key reasons investors have preferred shares over bonds in recent years. If we turn to the UK equity market, this valuation metric does look particularly favourable given the generous dividend yield on the index, reflecting the relatively high pay-out ratio.

Whilst we have increased the weight we attach to our equity negative risk scenario to reflect recent unfavourable newsflow, we nonetheless maintain our constructive central scenario, which is that equity returns will be broadly in line with the solid growth in corporate earnings we expect to see over the next 12-18 months. However, investors will need to become more accustomed to a return of market volatility, reflecting reduced central bank influence over financial markets and a return of the business cycle.

Finally, I thought I’d highlight a couple of points about equity investing: corporate profits rise over time and tend to be less volatile than equity prices. This suggests that equity investors who are patient are likely to be rewarded over the longer term.

The chart below shows US corporate profits (which are currently in excess of $2trn) and the S&P500 going back to 1949(I have shown them on a log scale to make the trend easier to see). You will observe that both corporate profits and the level of the equity market oscillate either side of a long term uptrend. Happily, they are both currently below this trend line which, despite the views of the doomsayers, does not suggest that we are in “overheated” territory just yet.

Data for all charts sourced from Bloomberg

Nothing in this article should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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