Recent Market Volatility – A Reality Check

Key points

  • The US share market is long overdue a decent correction. This now appears to be unfolding and may have further to go as higher inflation, a slightly more aggressive Fed and higher bond yields are factored in.
  • This will impact most share markets including Australian shares.
  • Recent market falls need to be kept in perspective.
  • In the absence of an aggressive 1994 style back-up in bond yields or a US recession – the pull back in shares should be limited in depth and duration to a correction and shares are still likely to have positive returns this year as a whole.
  • It’s likely to be a more volatile year than last year

Reality Check – Not Unexpected, Not Unusual

Whilst a market correction is not unusual, what has been relatively surprising has been the uninterrupted strength of global share markets over the last 12 months or so.

The recent falls on Wall Street have to be kept in perspective of the strong rises in this market over the previous 12 months. The Dow was below 20,000 at the beginning of 2017 and rose to over 26,000 in January 2018 – a rise of over 30%.

This rise came about after 12 consecutive monthly rises in the US market – the first time in history that this has ever happened and it has also been with volatility at record lows.

What Just Happened?

2017 was unusual for US shares. Against the backdrop of a strongly rising trend thanks to very positive economic conditions and President Trump’s business friendly policies, unusually every month last year saw a positive total return.

This, combined with a very strong start to this year of 7.5% and high levels of investor optimism, left the US share market overbought and vulnerable to a correction.

The past week has seen shares come under pressure as Fed rate hike expectations increased, partly reflecting an acceleration in US wages growth, and the bond yield rose sharply. From their recent high, US shares have fallen around 4% making it the deepest pullback since a 4.8% fall prior to the November 2016 US election. It’s likely the pullback has further to go as investors adjusts to more Fed tightening than currently assumed and higher bond yields.

This will impact most major share markets, including the Australian share market. However, the pullback is likely to be just an overdue correction rather than a severe bear market – providing the rise in bond yields is not too abrupt and recession is not imminent in the US.

Two key questions are how severe the back up in bond yields will be and whether a recession is approaching?

Severity of Rising Bond Yields

With global inflation risks rising, bond yields running well below long-term sustainable levels, and central bank bond buying starting to slow, the trend in bond yields is likely to be up.

Notwithstanding periodic spikes, the rising trend in bond yields is likely to be gradual as historically it will take a while for inflation expectations to turn up significantly after a long downswing.

The Fed is still likely to be “gradual” in raising rates and central banks outside the US remain a fair way off monetary tightening.

Today is quite different from 1994, when both share markets and bond markets posted negative returns on the back of bond yields rising rapidly.

Thanks to inflation expectations being anchored to much lower levels than in 1994, higher debt levels and more constrained underlying growth, the Fed and RBA won’t be able to raise rates anywhere near like what happened in 1994 (RBA hikes are unlikely until late this year at the earliest).

Is a US Recession Likely?

This is an important question as the US share market invariably sets the direction for global shares including the Australian share market – historical experience tells us that slumps in shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is.

So whether a recession is imminent or not in the US is important in terms of whether we will see a major bear market or not.

A number of factors would suggest that recession is not imminent in the US including;

  • high levels of confidence are helping drive stronger investment and consumer spending.
  • US monetary conditions remain easy (albeit with some tightening). The Fed Funds rates of 1.25 – 1.5% remains well below nominal growth of just over 4%.
  • The yield curve is still positive (its actually been steepening lately as long-term bond yields have been rising relative to short-term interest rates), whereas recessions are normally preceded by negative yield curves.
  • Tax cuts and their associated fiscal stimulus are likely to boost US growth at least for the next 12 months.
  • We have not seen the excesses – massive debt growth, overinvestment, capacity constraints or excessive inflation – that normally precede recessions.

As a result, earnings growth is likely to remain strong in the year ahead, whilst the December quarter US earnings reporting season is coming in much stronger than expected.

Conclusion

Following 12 consecutive months of gains in the US share market the current market falls, whilst unpalatable, are actually well overdue. It is highly unlikely that we will see the same gains on overseas markets that we saw in 2017.

While the trends for global economic growth continues to be positive with many upgrading their outlook for 2018, this does put pressure on Central Banks – for instance the US Fed is expected further rate rises throughout 2018.

The pullback in the direction-setting US share market is likely to be limited in depth and duration to a correction.

While share markets will likely rebound at some point, it is likely we will observe an increased level of volatility in share markets over the course of 2018.

If you would like to discuss the above please feel free to contact our office on 5229 6882.