Finally, this month, we had something of an equities’ correction, with an initial 10% creamed off US stocks despite guru-speak of a “blow-off” phase aggressively higher. The crucial 200-day moving average has held, the US market promptly reversing half its drop, so far flagging “correction” rather than a bear market.
Yet sellers prevailed after the 21 February-released minutes of the US Federal Reserve Board, revealing a strengthening economy has bolstered central bankers’ intention to keep raising short-term interest rates this year. The chief risk is US tax cuts happening too late in the economic cycle, liable to accentuate inflation and require more determined rate rises by the Fed.
Recession could also follow, amid record levels of personal and corporate debt. Thus, perception is being jolted from a Goldilocks scenario of modest growth and monetary stimulus (that has long-supported equities) to the disruptive equivalent of Lady Gaga. Notice how Barclays (BARC) had a tell-tale in its 22 February prelims: how payment delinquencies are increasing after red-hot growth in US credit card debt.
Stocks will ultimately take their cue from company figures, but with Q4 2017 updates out of the way, macro speculation is likely to rule the roost. Market volatility will persist for at least a month until Q1 2018 numbers help define the trend.
A reminder, global assets plunge with US stocks
Recalling the 2008 crisis, there was nowhere to hide beyond cash. Even gold plunged, despite allegedly being a touchstone for wealth preservation when trouble strikes. More recently, strategists have advocated holding European and Asian stocks as US valuations grew ever-richer, but, as soon as steam has whistled out of US stocks, they too plunged in sympathy.
Crude oil also accentuated losses in oil & gas stocks, and see how it is down again in response to latest Fed minutes. Thus, private investors are in a dilemma whether to engage “market timing” or ride all this out.
Personally, I think ensuring sufficient cash reserves is wise, given the cracks now manifest in the edifice of US stocks, both to protect wealth and later take advantage of any slide. Risks of a further correction are evident, and liable to take other markets down again too. These outweigh minimal returns from cash, while inflation has yet to seriously rise.
Is ‘buy the dips’ now discredited?
The tactic has worked consistently well for investors since 2009 because central banks have back-stopped markets with stimulus. It remains to be seen if they resume QE in the teeth of another crisis, but for now both the Fed and Bank of England are reverting to their prime role: containing inflation with interest rates.
Bulls contend that this reflects economic strengths, though I’d mind what is the effect on record debt. In such a situation we see equities falling whenever “rate rises faster than expectations” narrative bites.
Be aware also, rising long-term bond yields – on 10-year US Treasuries, up from 2.4% to 2.8% this month alone to a four-year high – pressure equities. Moreover, US tax cuts mean higher debt issuance and investors could demand still higher yields if stability of the US economy is in question.
Amid the uncertainty, charts can have a self-fulfilling effect as more traders latch on. If the US market can hold support above its 200-day moving average, like it has done so far, then in the short term “buy the dips” will have been affirmed as the right strategy.
UK context is firm, if pregnant with risks
My reading of end-2017 trading updates is overall robust. As yet there’s no net trend to warnings: even the much-maligned retail sector has shown positive surprises, while known dogs bark on. Debacles at Carillion and Capita (CPI) underline an outsourcing sector muddled in its ways – especially to ensure adequate operating margins – though mind how Carillion’s £900 million debt on liquidation means smaller suppliers are owed £141,000 on average, those medium-sized £236,000 and those larger £15 million. Not all of this will be insured, hence the risk of a negative domino effect.
Cyclical firms are not yet showing signs of downturn creeping in, to give cause for alarm. In the FTSE 250 (MCX) index, a profit warning from AA (AA.) and 30% plunge in the shares is quite high profile, but its lower membership may reflect competition than consumer spending, and its stretched balance sheet has posed risk to the dividend.
So, if I’ve a general concern, it’s the seemingly rising extent of balance sheet opportunism that reflects nearly a decade of low interest rates and a mature business cycle: e.g. acquisitions testing prudent levels of debt; some dividend payouts in need of a trim; also trade debtor/creditor imbalances, as if late payment to suppliers is massaging reported cash flow and profit. Even a perceived “quality growth stock” such as CVS Group (CVSG) begs questions in this regard.
Banks offer encouragement though Brexit remains a caution
Meanwhile, UK-oriented banks are a good litmus test of the economy and Lloyds Banking Group (LLOY) has declared a robust performance and prospects. It plans to lend an additional £6 billion to UK small businesses in the next three years, and £10 billion more to first-time home buyers. Confidence at least, if inviting parallels with the 2005-07 credit boom (if you recall the plethora of bank loans’ marketing). Mind its share price will remain sensitive to economic expectations.
The bogeyman is what extent Brexit hurts those firms closely tied into EU markets, according to what (if any) trade agreement is achieved. Also watch its effect on multinationals invested here – especially those which have replaced the domestic car industry – in terms of employment. Brexiteers have sneered at Remainers who warned of trouble from June 2016 onwards, but the challenges of leaving the EU are only just starting and adjustment will take years.
Yet China may mitigate current risks for the UK and US
While attention naturally focuses on the US, and Brexit pervades our news headlines, be aware prospects for China may be strengthening for the next year or even more. For what forecasts are worth, The Economist Intelligence Unit (EIU) has raised its 2018 real GDP forecast from 5.8% to 6.4% on the basis that indications from a Central Economic Work Conference imply the authorities will not pursue a concerted deleveraging drive this year.
After President Xi Jinping was emboldened by a Communist Party reshuffle last October, the expectation had been for credit supply to reduce and action be taken against profligate state-owned enterprises; it better to tackle such issues sooner rather than risk financial instability later in his presidency.
But economic policy language has altered more towards regulation of opaque parts of the financial sector than a clear effort at cutting corporate debt. The government retains its 2017 6.5% real GDP growth target, for 2018. EIU analysts have raised their forecasts for investment, private consumption, exports and money supply, despite the likelihood of interest rate rises to curb capital-outflow to the US. Property is seen as set for a revival, partly to meet GDP targets, with low-cost housing stimulating construction activity – despite this not re-balancing the Chinese economy from investment, as is the aim.
For global exporters, Chinese incomes continue to grow quite rapidly and reduced import taxes on some goods will support consumption. Mind a risk in growing US-China trade tensions. The EIU’s revised view doesn’t anticipate a fall in economic growth – to about 4.3% for the 2020’s – until 2021, but it raises the risk of a downturn if necessary tough measures remain delayed after 2020.
Thus, China retains its mystique and looks likely to help support the Asia-Pacific region if not the US and UK through our current challenges, so long as solutions can be found on trade.
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