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The correction that never happened

3 October 2017 12:58 am - 0     - {{hitsCtrl.values.hits}}

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BY Steve Brice

Global equity markets have gone without a 5 percent drawdown for more than a year and they haven’t suffered a 10 percent correction since the start of 2016. The stock market has powered through several surprise events – Brexit, President Trump’s election and North Korea’s heightened belligerence – seemingly without missing a beat. How are we to make sense of this unusual trend and how do we prepare for the inevitable pullback? 


To take the first question, the enduring equity market rally is being supported by three powerful forces – improving macroeconomic fundamentals, solid corporate earnings and abundant liquidity. Working in tandem, the three factors have provided broad-based support for the market’s stellar performance. 


Starting with the macroeconomic backdrop, for the first time since the 2008 financial crisis, the world economy is seeing synchronised growth fuelled by both the Developed Markets as well as the Emerging Markets. This is a sea-change from the aftermath of the crisis, when initially the Emerging Markets, propelled by China’s unprecedented fiscal stimulus and later the US, took turns to support global growth. Over the past year, we have seen Europe and increasingly Japan, joining in as global economic engines. Better still, the acceleration in global growth has been accompanied by weaker-than-expected inflation, creating the so-called ‘Goldilocks’ environment – which is positive for risk-taking. 


The favourable macroeconomic backdrop has filtered through to corporate profits. For instance, consensus estimates indicate the US, Euro area, Japan and China are all expected to report more than 10 percent earnings growth this year and over the next 12 months, providing a fundamental support for equities.


And then there is the abundant global liquidity as a result of still-extremely accommodative monetary policies in most Developed Markets (including the US, despite the Fed raising interest rates). The easy financial conditions worldwide are also reflected in high levels of cash held by institutional investors which have been deployed every time the market has suffered a hiccup. This has acted as a bulwark against deeper corrections over the past year.


So what could unsettle this constructive environment for equities? We believe there are two likely sources of near-term risk: 
First, we expect inflation expectations to rise somewhat in the coming months. At some level, this may be reassuring, as it would resurrect the so-called Phillips Curve – the long-held theoretical relationship between falling unemployment and rising wage pressures – which has been written off by so many observers. While the Phillips curve is clearly not a precise tool when forecasting future inflation, the underlying theory behind the relationship remains valid. As job markets tighten across the Developed Markets, the risk of inflation picking up increases, although the timing and extent of this acceleration remains highly uncertain. 


As inflation returns, more and more central banks are likely to focus on removing some of the monetary accommodation that has been in place following the global financial crisis. The central scenario is that this is likely to be a gradual process that gives ample time for markets to digest with limited volatility. However, there are always risks to this scenario. In any case, the process is likely to put gradual upward pressure on bond yields, making them increasingly competitive relative to expected returns from equities. 


The second source of uncertainty is upcoming event risks. These include increased tensions between the US and North Korea, the US debt ceiling debate and the Fed’s start of balance sheet tightening, the ECB starting to withdraw its ultra-loose monetary policy and the US’ more confrontational approach on trade issues with China and Mexico. The North Korea-related risks have clearly gone up with the recent nuclear test and the successful firing of an intercontinental ballistic missile with the potential to reach the US mainland. North Korea’s increased belligerence raises the risk of a miscalculation. 


The above factors may cause some indigestion for equity markets in the coming one to three months. However, we do not believe they will be sufficient to derail the bull market for global equities, now in its ninth year, given the robust fundamental backdrop highlighted earlier. To recap, corporate revenue and earnings growth continues to surprise positively in major markets on the back of accelerating and synchronised global economic expansion, supporting high-equity market valuations. Meanwhile, contained bond yields and a gradual pace of central bank policy tightening are likely to continue providing a favourable environment for equities. 


Hence, we doubt that any pullback, while overdue, will be deep or prolonged. It would likely take a significant escalation of risk events to pull equity markets sharply lower, given the still extremely supportive fundamentals. Therefore, we would prefer to ride out the potential volatility and take a dollar-cost averaging approach to equity investments, accelerating purchases on any market weakness.


(Steve Brice is Chief Investment Strategist at Standard Chartered Private Bank)

 

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