Why this week’s equity market drop is both good news and bad news for investors

While the drop may signal the beginning of an overdue market correction, fundamentals remain stable on the back of a strong global economy

THE huge market correction and quick recovery on Monday and Tuesday is both good news and bad news for equity investors.

The bad news is that the bungee jump in share prices may signal the beginning of a big and prolonged market correction that is long overdue, as well as more extreme volatility in equity prices.

The good news is that market fundamentals remain very stable on the back of a strong global economy, synchronized growth and decent corporate performance.

“The US stock market falls this week will have understandably unnerved investors the world over. For now, the concerns are less profound and actually stem from a bright economic backdrop. The US economy is growing at a pace that may create too much inflation, which in turn may necessitate rapid increases in interest rates,” says Andrew Oxlade, head of editorial content at Schroders, following a 4.1% drop in the S&P 500 on Monday, the largest one-day fall in six years.

For a short while, there were fears of a contagion effect as the Asian markets also dropped sharply, mimicking the US market, but the following day’s sharp two percent rally has allayed such fears temporarily.

“The backdrop remains a strong economy with decent corporate fundamentals, and after a period of a week or two we expect that markets will stabilize, albeit with less froth,” says Eoin Murray, head of Investment of Hermes Investment Management.

The strong fundamentals are evident, based on global growth that has picked up speed over the turn of the year, as consumer spending, business activity, capital expenditure and trade data improve across Europe, North America and Asia.

“At this phase of the business cycle, companies are managing the pressures on corporate margins, underpinning robust profits growth that is proving supportive for global equity markets,” says Jeremy Lawson, chief economist of Aberdeen Standard.

This positive outlook is, however, tempered by the view that world growth has stopped accelerating and hit a plateau.

“After an acceleration in the last quarter of 2017, is world growth hitting a plateau? This is what Markit’s manufacturing sector surveys seem to suggest. The swift growth seen right throughout 2017 has ground to a halt, and while indices all stand at admittedly impressive levels, reflecting swift growth in economic activity, they are no longer rising,” says Philippe Waechter, chief economist at Natixis Asset Management.

Still, on the basis of this long-term positive economic outlook, some fund managers argue that it is not yet the time to go bearish on equities, even in the wake of last Monday’s unnerving market correction.

“Current conditions vindicate our continued bullish stance on equities in developed markets and emerging markets, Asia more than Latam. Valuations are high, but they are justified by upwards adjustments to expected earnings growth,” according to Pictet Wealth Management’s House View, issued on February 7.

But although the long-term overall prospects for equities remain positive, there is consensus that the asset class will remain extremely volatile, while the much-anticipated major correction may happen sooner rather than later.

“The bad news is that the numbers currently show that those investors in short volatility ETFs, quants and CTAs with leverage will be the investors hit the hardest this time. Whilst we may see a couple more drops this week and next as 2017’s euphoric investor sentiment dies out, the markets are down, but not out. Not yet anyway,” says Murray of Hermes.

Rory Bateman, head of European and UK equities at Schroders, also warns about volatility, saying: “There has been a substantial pick-up in volatility, with the VIX index increasing more than three-fold since the lows in early January.”

Volatility in the market has been at historic lows for an extended period, which is consistent with the relentless increase in equity markets that we have witnessed over recent times.

Bateman says the current market selloff is related to an unwinding of trades that have been predicated on continued low volatility.

“It is very difficult to identify the quantum and longevity of this unwinding, but we think it will be a relatively temporary phenomenon,” Bateman says.

“My time horizon is much further out into 2019, where I believe a perfect storm of rate rises, central banks unwinding balance sheets and inflation will drive a much larger market correction,” says Murray.

Date

8 Feb 2018

Share this article