What Chance Of A Big Correction?

Rudi Filapek-Vandyck

The share market is, above anything else, a mix of conflicting emotions, in particular when assessed on a short term scale. Sometimes even a hint of potential risk on the horizon can set off a stampede of money fleeing onto the sidelines, as has happened on many an occasion, but that's simply the emotional side that makes anything involving human sentiment transitory and unstable by definition.

For temporary share market weakness to morph into something much more sinister we need a lot more ammunition than simply human emotion. There needs to be a genuine prospect of economies facing a recession, or for corporate profits to wither, or for a military conflict to break out, or something of equally severe negative impact.

The global economy is experiencing a rare synchronised move upwards with all major economic regions improving, for the first time since pre-GFC, supporting global GDP at a level not seen for a long while. This is reflected in corporate profits and margins which, around the world, are in the healthiest shape for a long while. But asset prices are far from cheap, while the era of exceptional, abundant liquidity is coming to a close.

Already, the Federal Reserve is reducing its balance sheet and lifting the official cash rate with other central banks expected to follow.

Arguably, risks have been rising all throughout 2017, but sometimes investors simply don't want to pay attention. I think it was the prospect of the corporate tax cut in the USA that outweighed just about everything else. Now that those tax cuts are in place, and we all come to the conclusion that any infrastructure program will be long-winded and medium-term at best, while geopolitical tensions are rising, as well as political risk inside and outside the White House, we are left with many reasons to feel less confident about the outlook, and maybe pay more attention to potential booby traps.

Many a share market commentator tends to refer to healthy economies when asked about the direction of share markets, but history shows there is not a strong relationship between the two. One reason as to why is because financial markets try to look forward, into the future. So it matters a lot less about what is now, or even tomorrow, and a lot more about what we, collectively, think/hope/fear might be on the horizon.

Back in early 2008 global markets were selling off and Goldman Sachs came out with the bold prediction the US economy was descending into recession. At that time, global growth seemed solid, corporate margins and profits were on a high, but three quarters down the track Lehman Bros folded and the US and the global economy were staring into the abyss.

This time around the Federal Reserve is intent on removing the excess policy stimulus that has supported financial markets post-GFC, and a lot has changed since the last tightening cycle. From demographics to technology, from ultra-low interest rates for an extended period of time to populist, strong-man politics overpowering democracy, and so many new elements in between. Typically, equity investors are not used to having to spend a lot of time wondering what global bond yields might do, and what the potential implications might be, and they feel uncomfortable about it.

Look no further than the many predictions that inflation is about to break-out; that bond yields are on their way to 4% (from below 2.9% now); that elevated asset prices will de-rate (if not deflate); that gold is back as a safe haven, together with cash; that government bonds are now in a bear market and the only way forward is down in price, and up in yield; that the technical picture is deteriorating for equity markets; that the sell-off in crypto currencies is a harbinger of what is about to happen to other risk assets; we have yet to see the global debt bubble burst, et cetera, et cetera.

Two certainties we have, apart from the usual ones about death and taxes: most of these predictions will be proven wrong. This, however, won't prevent investors to bebeing less sanguine about the outlook this year because even the most ardent bull will have to acknowledge that, overall, risk is on the rise.

Asset prices are not cheap. But we need a major change in the landscape to pull equity markets down by -20% or more. What can it be?

The biggest fear among investors is that inflation is making a come-back and thus more central bank tightening will be necessary; this pushes up bond yields, creating ever stronger headwinds for equity valuations. It also brings forward the idea that at some point the Fed Funds rate will reach its neutral level, meaning the next hike will be the one step too far.

History shows us central bankers always move one step too far. Firstly because monetary policy works at great delay, it's not an exact day-to-day framework with immediate impact. Secondly, economies are fluid. All we know today is the neutral rate setting is a lot below what it used to be. But we don't know exactly what it means, neither where exactly the new neutral is located.

It cannot be denied inflation in the USA is rising and bond yields have risen in response. But equally important: this does not imply the next step is a break-out with the Federal Reserve scrambling to stay in control. The best description I have come across, and I believe it's from economists at Citi, is that financial markets have been pricing out the death of inflation.

Previously, financial markets were focused on deflation, with central bankers putting in their might to retain some sort of price inflation into the global system. Financial markets have now accepted that inflation is not completely dead and buried. This is all that has changed over the past six months or so.

It doesn't mean one-way traffic for bonds. It doesn't mean inflation is about to explode. It doesn't mean, by default, equity markets are poised for a big correction. There is a lot more impacting on and inside today's economies to make the present sufficiently different from the past. But fear is an important driver, it can be all-consuming under the wrong circumstances and with so many market participants unsure about what exactly is the trajectory of inflation in the US, nobody should be surprised market volatility has made a come-back with a vengeance.

My view is too many commentators and experts too eagerly predict inflation will only move higher from here. Note global bond markets are not reflecting any such scenarios. This even to the dismay of central bankers like RBA Deputy Governor Guy Debelle who likes to think the battle against deflation has been won, and bond markets should be more reflective of potential upside risk.

Bond markets can be wrong, just like equities. A popular saying is that bonds have successfully predicted the last few recessions more than 15 times. They might be proven wrong tomorrow. After all, it wasn't that long ago economists in Australia were tripping over each other to predict the next RBA rate hike and local bonds were reflecting just that.

Those same economists have gone eerily quiet. Forecasts about Melbourne Cup day 2017 rate hikes, or February-May 2018, have proved to be unquestionably wrong. Most forecasts are shifting into 2019, sometimes into late 2019. In financial markets, just like in daily life, the speed and timing of events is of crucial importance. Australian bonds today are suggesting the RBA is in no hurry, with plenty of time on its hands, and no disaster scenarios, like a return to the high yielding eighties, should be on the agenda.

Equally important, the opposite scenario remains just as valid. There is an argument to be made global economic momentum peaked late in 2017, and there's now an underlying shift towards a decelerating pace. Look no further than, for instance, to the recent changes in predictions for Q1 GDP growth in the USA by the Atlanta Fed.

Between last week and February 1st, that forecast for Q1 USA GDP has declined to 1.9% from 5.4%. This is a widely followed economic indicator by many a professional investor.

Under a not so favourable scenario, global growth is now decelerating, also because China is putting more focus on quality. Were this slowing to extend, and to become front of mind for investors, while the Federal Reserve staunchly sticks to its tightening agenda, one can see how this combination can easily unsettle investors nerves.

Maybe today's bond market is balancing out the probabilities between these two opposing outlooks?

Finally, the world is swimming in debt and we now have a President in the White House who is likely to increase government debt and future liabilities even further. Plenty of worrisome analyses around also about what potentially can go wrong with highly indebted consumers in countries like Australia and Canada. Analysts at Deutsche Bank recently published a study into zombie companies. These are companies which cannot service its debt and only continue to operate with government support, and for as long as interest rates stay low.

After so many years of ultra-low interest rates, cheap money if you like, there is bound to be some unknown, hidden vulnerability inside the global financial system. Very few were aware in early 2008 there was excess in subprime loans and related derivatives originating from a fraudulent Wall Street, yet once the system tightened, weaknesses simply opened up more weaknesses.

It would be quite naive to think this time the transition will be nothing short of smooth. In this context, anti-volatility investment products blowing up in late January might as well serve as a canary in the coal mine. As the economic cycle matures and global liquidity tightens, there will be more of such sudden hiccups. That's almost a guarantee.

Yet, none of all this means equities cannot possibly climb the wall of worry for another year, though I am quietly confident 2018 won't be a repeat of 2016, nor of 2017. The best we can do is accept that risk is on the rise, and so will be market volatility and uncertainty.

It remains far too early to predict which of the scenarios will gain the upper hand in the months ahead. It may yet turn out the answer is: none of the above. That wouldn't be the first time either.

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Steve Karp

Rudi, it is always a pleasure to hear a voice of reason. I enjoyed this article, thank you. Steve

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