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In January 2016 and 2017 I felt and expressed caution about the outlook for equity markets based on how far they had come since the first quarter of 2009, and also in recognition of the economic and political uncertainties that prevailed. On both occasions, my caution proved totally and utterly unfounded and equity markets continued to power ahead absolutely oblivious to the ongoing economic and political challenges in the shape of events such as Brexit and the surprising election of Donald Trump, and despite the fact that US markets in particular were starting to look very expensive.
Of course, the election of Donald Trump, rather than being taken as a negative, actually propelled the US markets to stellar heights, based on his proposals for corporate tax reform and his infrastructure investment plans. They ignored his anti-free trade rhetoric, which would ultimately damage global growth and corporate health if he succeeded in turning his rhetoric into action. Investors were also inspired towards equities by the lack of alternatives in an environment of artificially low bond yields and official interest rates.
Coming into 2017, I had similar reservations, but they were not held with much conviction and quickly dissipated in the early days of the New Year. Once bitten, twice shy! Following the agreement on Donald Trump’s corporate tax package and lots of optimism about global growth prospects, markets surged ahead in January and US markets, in particular, breached several record highs. Coming towards the end of the month, all looked rosy in the garden.
Alas, over the past week or so all hell has broken loose on markets and serious losses have been suffered. Volatility levels have increased dramatically, having being dormant for some time. Market sentiment has been shaken by a number of events, which combined to undermine confidence. First off, Berkshire Hathaway, JP Morgan Chase and Amazon announced a health insurance initiative that ultimately could prove very disruptive for the existing players in that market. Then, Apple’s fourth quarter mobile phone sales disappointed. Last Friday, the US employment report was very strong, with growth of 200,000 in non-farm payrolls. This very strong piece of data freaked the markets on the basis that it was interpreted as a portent of higher inflation and more aggressive interest rate tightening from the US Federal Reserve than the markets had built in.
I am not convinced that any of these three developments, either individually or combined should be sufficient to trigger the sort of market correction we have experienced to date. However, the market reaction just shows how nervous sentiment has become, and any old excuse has been used to offload equities. When one is of a nervous disposition, any old noise will scare. The fear and the volatility were of course compounded by machine-based trading.
Only a Charlatan would claim to know with certainty where markets might go from here. On the negative side, US valuations in particular are very high; bond yields are rising with the US 10-year Treasury yield at 2.8% (some US analysts believe that if this breached 3%, it would signal a much more serious equity market correction); we are approaching the end of quantitative easing (QE), which should push bond yields higher over the next couple of years; and official interest rates look set to gradually rise everywhere over the next couple of years. On the positive side, the global growth story is very compelling; inflation remains relatively well behaved; Trump is good, at least in the short term, for Corporate America; and corporate earnings in general look very healthy. In other words, the economic and corporate fundamentals look reasonably positive and supportive of markets.
It is hard to call which side will win out over the coming months, but there is a sense that sentiment has become very fragile and volatility looks set to remain high. On top of all of this, the current equity cycle is almost nine years old and valuations are quite challenging.
It would appear on balance that we are entering into a period of significantly greater volatility and nervousness, and notwithstanding the fact that US markets closed higher on Tuesday night and European markets have opened stronger this morning, it is hard to believe that we are out of the woods just yet. Uncertain times ahead, and a more cautious approach to investing looks the order of the day for the moment. However, I struggle to believe that this is the beginning of a sustained bear market and in many ways, a healthy correction of up to 20% would remove a lot of froth from the market. Time will tell!
The views and opinions expressed in this article are those of the author.