Global share markets have been volatile this week as investors adjust to an environment of strong economic growth and rising interest rates. In the past when there have been bad economic news markets rallied knowing Central Banks would ease monetary policy, now as the economic news improves the market reacts negatively as we have seen this week. Basically, its good news leading to a correction. Large passive ETF funds are likely to be exacerbating the market swings as they must rebalance their portfolios (you may like to read my article ?Debunking the active, passive investment debate?). There is no need to be concerned or to make knee jerk decisions but instead now is a time to reflect, stay the course and seek long term investment opportunity, this is a correction not a bear market.
Some would say that the pull-back in US and global equities has been a long time coming. The US markets have had a record run with the S&P 500 going 310 days without a 3% drawdown and 402 days without a 5% drawdown. Some have even been saying that irrational exuberance is back and discount brokers noting that retail investors have been flooding the market increasing their allocations to equities to the highest level since 2000.
So, what has prompted the declines for key US share indexes ? declines that have spread to other markets in Europe and Asia?……….the latest US jobs report. US non-farm payrolls (employment) rose in January, ahead of forecasts. The jobless rate was unchanged at 4.1 per cent as expected. But the key result was wages or average earnings, up by 0.3 per cent after a 0.4 per cent gain in December. That put annual wage growth at an 8-year high of 2.9 per cent. That?s right, strong US economic data was one factor prompting a sell-off in stocks.
The worry is that stronger wage growth could lead to higher prices (inflation). That could lead the Federal Reserve to be more aggressive in lifting rates. Although, higher interest rates aren?t necessarily bad news if prompted by a stronger economy. But, if rates rise it could lead to slower consumer spending, slower demand for new homes and slower growth in profits, thus affecting share prices. Here the concerns relate more to the Federal Reserve hiking rates too aggressively, thus slowing the economy too much. If the rate hikes are measured, keeping economic growth and inflation on a sustainable footing, it is a positive development. Also, in terms of the sell-off it must be remembered that US shares were priced for perfection at around 19 times earnings. The more ?normal? relationship is for shares to be around 15 times earnings. Still, US companies have produced stellar earnings over the reporting period. So, it is understandable that some ?irrational exuberance? would emerge.
The chart series on the right was published by BCA Research on February 2nd, the day before the start of this current correction. Comments included:
- Global equities are technically overbought, making them highly vulnerable to a correction.
- The cyclical picture for stocks still looks good, thanks to strong economic growth and rising corporate profits, but the recent spike in bond yields is becoming a headwind.
This is nothing that I did not comment on in last month?s update and the reality is that technical factors drive stocks overt he short-term horizons of on-to-three month?s and business cycles drive stocks over the longer-term horizons of five years and beyond.
In contrast to the technical correction we are witnessing now, the cyclical outlook for equities locks reasonably solid. Growth in the Euro area remains strong, growing by 2.05% in 2017, the fastest pace since 2007. US growth is gathering steam with corporate profits ripping higher. Approximately 45% of S&P 500 companies have reported 2017 Q4 results and 80% have beaten consensus EPS projections.
US Q4 GDP growth was 2.6%, not as strong as the 3.2% reported in Q3. However, domestic spending was notably stronger. Real consumer spending was up, residential spending was up, and business investment spending was up. The widening of the US trade deficit is a negative but is not a concern despite the media attention. Most indicators of US economic activity remain strong; ISM remains in expansionary territory; business and households remain confident in spending. US businesses are experiencing strong profit growth and households are increasingly fully employed with wages rising faster then inflation. We expect the US Federal Reserve to continue its slow pattern of interest rate hikes on its way to a neutral setting of about 3%. This is no reason for concern, this is not contractionary monetary policy or the US Fed putting the brakes on.
China continues to be an important part of the strengthening global economic them. China increased its economic reform in 2017 and enjoyed the economic equivalent of having its cake and eating too. There will be more economic reform in 2018 but we still expect GDP growth of about 6.5% or better making it a strong contributor to global economic growth.
Critically for Australia Iron Ore stockpiles are reaching new highs in China. The RBA?s commodity index has also rolled over from recent highs. The RBA remains patient, seeing no immediate need to change interest rates in either direction.
The household saving rate has dropped, while debt levels are exceptionally high. This will limit consumer spending. Business confidence has dipped as has the PMI new order index. In short, the RBAs ability to raise rates is limited and any increase is still some time off, perhaps August or September if the infrastructure boom causes full employment and wage increases.
As I said at the beginning, this is a correction not a bear?market. US growth will soon receive an additional boost?from tax cuts. The timing of the tax cuts is poor given the?strong economy and could cause a spike in inflation and?interest rates but for now inflation is tame enough globally to limit the likelihood of interest rates pushing up too aggressively, causing economies to cool. Corporate tax cuts are also likely in Japan and Australia but are better timed and will support growth in those economies.