March was another volatile month for financial markets. The Vix measure of implied equity volatility reached 20 per cent, double the subdued level seen at the start of the year. The catalyst for this development was the announcement by President Trump of tariffs on Chinese imports totalling $50bn. Another factor which affected the equity markets was weakness in technology stocks following allegations that Facebook may have misused client data and a number of public criticisms of Amazon’s business model and level of tax contributions.
Taken together, these developments wiped out the recovery seen in the major stock indices seen since February’s sharp correction. In local currency terms the S&P500, NASDAQ, Nikkei and Hang Seng Nikkei each lost roughly 2.8 per cent. Elsewhere, the Eurostoxx lost 2.25 per cent and the FTSE100 declined by 2.4 per cent. The falls in overseas equity markets were larger when translated back to sterling, reflecting the fact that it rose between 1 and 1.75 per cent against other major currencies.
Elsewhere, economic data released during the first quarter has been a little disappointing. We have seen a moderation in consumption growth and a downshift in manufacturing momentum. This reflects a combination of the lagged effects of higher energy prices, a seasonal bias for weaker first-quarter data in recent years and adverse weather. We do expect much of this to be reversed in the second quarter but, for the time being, this has been a headwind to the equity markets ahead of the upcoming first-quarter corporate earnings season.
Against this backdrop it is fair to say that the narrative in financial markets has become much less upbeat in recent weeks, as investors fret about a possible trade war and the risk of tighter regulation and increased taxation of the large technology firms, so some short term caution may be justified. In addition, the deceleration of economic momentum as the US Federal Reserve continues to tighten monetary policy has made many investors worry that the economic expansion seen since 2009 may be nearing an end.
At this juncture I shall nail my colours to the mast and say that I do not think that there is currently enough evidence to support the late-cycle thesis. As a consequence, and despite some near term market headwinds, I also feel that it is too early to call an end to the bull-run in equities. Why do I think this? Well there are a number of developments one would expect to see on the cusp of the next downturn. Here are the main ones to consider:
- Overheating in the real economy, evidenced by an unwelcome rise in inflation, which causes central banks to tighten monetary policy to the point at which we see a material slowdown in activity which is accompanied by weaker corporate earnings and poor equity market returns. If we exclude the UK from this – the rise is inflation has stemmed largely from the one off effects of sterling’s 2016 depreciation – inflation, particularly in the developed world, is running some way below the main central banks’ targets. Whilst the US Federal Reserve has begun to tighten its key policy rate and wind down it quantitative easing programme, this process is likely to be a gradual one. Elsewhere, the Bank of Japan and the European Central Bank will keep policy highly accommodative for some time to come.
- Overheating in financial markets. Equities reached all-time highs early in the quarter, but it is by no means clear that financial markets have been fuelled by speculative excess. Cash levels which many investors have been holding have been generally high and leverage (borrowing to fund asset purchases) has been modest by historical standards.
- Deteriorating credit quality. As the cycle matures, companies engage in increasingly shareholder friendly behaviour, often at the expense of bondholders. This can involve increasing debt levels to finance share buybacks or M&A activity. This may begin to be an issue for markets because whilst default rates a low and falling, the degree of leverage in the corporate sector is rising, which could make companies vulnerable to rising interest rates. We are watching this factor closely.
Market sentiment is clearly fragile and the newsflow unhelpful, but equity markets have already made a reasonable downwards adjustment without any de rating of the earnings outlook. Whilst market volatility may remain elevated, particularly in the short term, we remain reasonably constructive on equities as we head through the second quarter.
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