This week, we focus on how to interpret the last few rather interesting days of market activity. The theme underlying recent weekly reviews has been the market sell-off – in particular, what caused it and whether it will continue. The common view is that the sell-off reflected a genuine slowdown in the global economy, particularly in Europe. However, the market reaction was – not for the first time in the history of financial markets – greater than the macro data in isolation might have warranted. We also stated that we are not expecting a sustained slowdown in global economic conditions. The severity of the sell-off also appeared to reflect technical issues, in particular some widespread long-equity and short-duration positions that were cut as risk assets fell, contributing further to the selling pressure.
So how does this analysis currently stand up? Last week there was a material rebound in risk assets: equity markets rose, spreads over high-quality sovereign bonds fell, and government bond yields themselves rose. As of Monday afternoon, some of this had reversed; there’s nevertheless been some recovery in markets. As a broad rule of thumb, the equity correction has been around 10% on average, and the average rebound up to the end of last week was some 4%. Government bond yields have reversed at a broadly similar proportion to their previous decline.
So what do we know now that we did not know a week ago? First, there has been some good economic data. The European purchasing managers’ index rose in September; Chinese GDP for the third quarter and industrial output for September surprised on the upside; and industrial output also rose strongly in the US last month. It’s also worth pointing out that the current earnings round in developed economies has also been very supportive. US corporate earnings over the year to the third quarter rose at close to a double-digit rate (based on some of the companies that have reported so far) and numbers look similar, if a bit lower, for companies which have reported elsewhere in the world. Finally, in Europe, the recently released results of the European Central Bank’s stress test on bank capital suggest that there is no longer a glaring hole in the heart of the European banking system, even if some individual institutions, particularly in Italy, may have more work to do in that context.
“Perfectly feasible” does not mean “inevitable”
If you add it all up, the soft patch that the global economy hit during the summer does appear to be reversing, although as always, we remain vulnerable to short-term noise in the data. Concerns that the market correction may have reflected some sense of deeper malaise in the global economy have therefore moved a little further offstage. Looking ahead, it does seem perfectly feasible that the global economy will continue to struggle through and that the remainder of 2014 to 2015 will be a period of positive, if less than stellar, growth. After all, global monetary conditions are very loose, global fiscal policy is becoming much less restrictive, financial conditions are easier than a couple of months ago, and there has just been a major fall in the oil price, which will help to put money into consumers’ pockets. And it also seems perfectly feasible that in this environment, inflation will remain low; inflation expectations will remain close to central-bank targets in the long term, and therefore, there will be little or no pressure for central banks to tighten monetary conditions. And if all of this happens, then it’s feasible to expect a diversified portfolio of growth assets to outperform very defensive assets such as cash or high-quality bonds – albeit, at pretty modest absolute returns given the extent to which valuations have normalized. Remember, there are few very cheap asset classes around, and there are some at which the pricing is more aggressive. Still, the correction in high-yield spreads in recent weeks means that some valuation support is now back in that asset class. However, “perfectly feasible” does not mean “inevitable.” The fundamental message behind the market correction is that the feasibility of the scenario just described may no longer be what it was. One month of good data does not, after all, suggest that the Chinese growth model is fixed or that Europe is on the verge of a strong, self-sustaining recovery that will push deflation concerns to one side. Indeed, last week, the good news from the output side of the purchasing managers’ report for the euro area was offset to some extent by a sharp decline in inflation in the services survey for the same area. The recent market correction has also led markets to push out potential monetary tightening from the US Federal Reserve (Fed) and the Bank of England from mid-year to the end of next year.
However, the lower level of bond yield does mean that fixed-income markets remain more vulnerable to a reversal of sentiment. This week, the Fed is likely to announce the end of its asset-purchase program, which over recent months has already been minimized very considerably. The largest casualty of the events of recent weeks is volatility, which had previously been very low across all asset classes for an extended period. This development was not irrational; we were simply in a very low-volatility macro environment. But as the range of possible macro outcomes broadens, so does the potential for markets to flip from pricing one regime to another. It’s difficult to believe that this process is going to stop. Therefore it is highly likely that volatility is not going back to the low average levels that we’ve seen over the past couple of years.