- Global equity markets fell sharply in December, particularly in the US. Volatility spiked while perceived safe-haven assets rallied
- This bout of volatility is likely to have been driven by concerns over a global economic slowdown, US politics and exacerbated by thin liquidity conditions
- We believe economic recession fears are misplaced. For example, US growth remains above trend
- Policymakers have ammunition to mitigate the adverse effects of downside risks, in our view
believe the latest bout of market volatility presents a buying opportunity for
global equities, particularly in the US. However, US Treasuries now look less
attractive to us on a valuation basis, although we continue to acknowledge their
relative value versus other DM equivalents
Global equity markets fell sharply in December, particularly in the US (Figure 1), with volatility – as measured by the VIX index (based on the S&P 500) – spiking to levels not seen since February 2018 (Figure 2). Meanwhile, perceived safe-haven assets such as US Treasuries, the Japanese yen and gold have all rallied in the past month.
Figures 1 and 2: Q4 2018 equity market performance, and VIX index/10-year Treasury yield
Whereas previous selloffs in 2018 (February & October) were mainly attributed to rising US Treasury yields adversely impacting the relative attractiveness of equities, Figure 2 tells us this cannot explain the latest market disruption. A number of other explanations are possible:
- Late 2018 has seen a number of disappointing economic data releases, with Germany and Japan’s economies1 both contracting in Q3. China’s activity data has also softened, whilst there are pockets of weakness in the US economy, particularly in housing*. US credit spreads have also risen in 2018, whilst the US Treasury yield curve is close to inversion (i.e. longer-term yields falling below short-term yields) – a traditional recession indicator. Overall, this has raised investor fears of a significant global economic slowdown in 2019.
- In the US, investor confidence may also have been dented by the US government shutdown, President Trump’s repeated criticism of the US Federal Reserve, and US Treasury Secretary Mnuchin’s attempts to re-assure markets over the previously little-discussed issue of banking sector liquidity.
- The extent of the market moves may also have been exacerbated by thin liquidity conditions during the holiday season and the impact of algorithmic trading.
Despite a general softening of activity data over 2018, in our opinion, fears of an economic recession in any of the major world economies in 2019 are likely overdone.
- The weakness in the eurozone and Japan partly reflects temporary factors (German auto sector disruptions and weather/earthquakes in Japan).
- China has loosened policy in recent months, which should eventually filter through to the real economy, and subsequently pass through to global activity.
- Despite concerns over the US credit and housing markets, according to our Nowcast (“big data” approach to tracking the economic cycle, Figure 3) the rate of expansion of the US economy remains well above trend. Figure 3 also shows us that world growth is becoming more trend-like2 rather than recessionary.
- We believe the shape of the US yield curve has become less reliable as a recession indicator in a world where the pricing of global government bonds has become distorted by large central bank balance sheets.
- Investors may also be underestimating the beneficial impact of lower oil prices on major net oil importer countries in 2019, including most major advanced economies and many emerging market (EM) economies (including China and India).
- Weaker US growth in 2019 could help the rest of the global economy if this caps Treasury yields and/or the US dollar, both significant headwinds to EM economic and financial market performance in 2018
1 Sources: Japan’s Statistics Bureau and Germany’s Federal Statistical Office. 2 Source: Bloomberg, 5-year global growth trend average is 3.2%.
Figures 3 and 4: Nowcasts versus trend, and global corporate earnings index
There are many risks on the horizon, such as global trade tensions, or a potential flare up in European politics (Italy, Brexit). However, we believe that, in aggregate, policymakers have enough ammunition – both monetary and fiscal – to mitigate the adverse effects.
We believe the latest bout of market volatility presents a buying opportunity for global equities, which in our view remain the best way to back “growth”. Although global economic growth moderated in 2018, this has simply taken the rate of expansion back to trend levels*. We believe the risk of a recession remains modest, and importantly, corporate fundamentals also remain strong, particularly the pace of global earnings growth (Figure 4).
Given the extent of the fall in US equity prices, and as the US economy continues to outperform other regions, we are less comfortable in our previous preference for eurozone and Japan equities over the US.
Interestingly, as Figure 1 highlights, EM equities were relatively resilient in Q4 2018, which implies a significant degree of “bad news” had already been priced in. This supports our recent decision to overweight EM equities, which we believe have the potential to perform well in 2019.
Meanwhile, the recent significant decline in US Treasury yields has sent the bond “risk premium” - the future reward for owning bonds over cash - back into negative territory. Nevertheless, we continue to acknowledge the relative value that exists between US Treasuries versus equivalents in other developed markets. Prospective risk-adjusted returns continue to be most attractive in shorter-duration Treasuries, i.e. those with a lower price-sensitivity to interest rate movements, and may still deliver diversification benefits in this fairly uncertain economic environment.
Finally, it is important to remember that although recent volatility may feel sudden and extreme, we believe this represents a return to a more typical market environment following an unusually calm 2017 in markets. In our opinion, further bouts of episodic volatility are likely this year, as investors adjust to a new stage of the business cycle amid a fading impact of US stimulus and central banks easing back from ultra-loose policy stances. Geopolitical risks also remain high and unpredictable.
As ever, we continue to monitor market developments and the global economic outlook closely.