Is there a correction on the horizon?

Risks are elevated and investors are nervous, so we sat down with Hamish Douglass, CEO and CIO, to revisit his previous warning of a significant market correction. We get his thoughts on how he views the various scenarios playing out and what the likely impact could be on markets. You can watch the full interview here.

Q. Hamish, you've recently commented on the potential for a 20 or 30% correction in markets on the back of rising interest rates. Are you able to expand on your thinking?

We think the probabilities of a market correction are very elevated. That doesn't mean it's going to happen, it just means people have to be very mindful and cautious that we're in an environment that's quite dangerous.

What could lead to that? First of all I think we have to recognise around the world that most equity markets and most asset prices, are at or near all-time record levels. At the same time, the major central banks of the world have announced plans over a 12-month period to withdraw around US$1.5 trillion of liquidity from markets. That's going to have upwards pressure on interest rates.

We've also got another very important element here, and that’s the state of the U.S. economy, which is in great shape at the moment. Unemployment is at a 20-year low, and the Trump administration has announced a very large fiscal stimulus over the next two years through tax cuts and expansion of the budget, probably about 2% of GDP each year for the next two years.

We've got this cocktail of very unusual circumstances in history. The biggest risk for markets is we get a jump in long-term interest rates, and there are a few scenarios that could play out. The principle one is the Federal Reserve and the ECB continue on their plans, and the stimulus in the economy doesn't trigger wages growth of any material aspect in the economy. If that happens, I think we will just get slowly rising interest rates, a bifurcating market where certain assets do well and others won’t, the economy remains strong but we don't get a major correction in markets.

The other side of that equation is we get some meaningful wages growth in the economy over the next 12 to 18 months. The U.S. Federal Reserve is behind the curve on where they need to be from the monetary policy point of view, and the market quickly reprices where the Federal Reserve has to go. We could get a big jump in long-term bond rates, maybe to 4.5% (they're currently around 3%).

If that was to occur and to occur rapidly, I think it's very foreseeable that markets could correct fairly quickly at 20 to 30% level.

Will that happen, won't that happen? History would tell you at some point there's going to be a point of inflexion, but there are some very strong secular forces at work in many economies of the world that are keeping wages growth low. Will we get a point of inflexion over the next 12 to 18 months? I think it's 50/50.

Q. What are some of the signposts or signals that investors and advisors should be looking out for?

I think that wages growth number and the economic growth in the United States is absolutely key here, and it's probably the most important economic statistic that the market's going to be reacting to.

If we go back to the 2nd of February this year, it was a very important day, because that was the day the Department of Labour announced the January wages growth number, and it came in at 2.9%, and shortly thereafter, the markets corrected by around 10%.

When we got into March and we saw the February numbers, wages growth had come back to about 2.5% and the market said, "Oh we're in goldilocks moment again. Rates aren't going to go up rapidly, and we're back to the races."

It's likely if we get a wages growth number above 3%, the Federal Reserve won't do anything in reaction to the first one, because they don't want to act too early or pre-empt. The risk is we get a second one that accelerates further, and then the markets say, "the Federal Reserve's behind the curve here."

I would focus on absolute economic growth and wage growth numbers in the United States. It's probably two key statistics that markets will be watching, and I would suspect interested investors will be doing the same.

 

For further insights from Magellan, including the full interview, please visit our website

 


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Magellan was formed in 2006 by Hamish Douglass and Chris Mackay, two of Australia’s leading investment professionals. The company specialises in global equity and listed infrastructure assets.

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