The abrupt market correction last quarter now feels like a logical response to gathering deflationary risks, and growing worries over the credibility of central bank policy. A fear of geopolitical fragmentation (especially the Syrian and migrant tragedies) has added to concerns. After recent falls, though, lower equity valuations and higher running yields are starting to offer value. Yes, profitability has been damaged for commodity and energy producers, and for the more indebted emerging world companies. On the other hand, though, sharply lower energy costs, renewed corporate restructuring and (over time) windfall export gains from the collapse of emerging world currencies offer huge opportunities. Meanwhile, with lower bond yields and interest rates, global equity income strategies are starting to look compelling.
For more than six years, the US Federal Reserve’s (Fed) stimulus policy has both supported a remarkable bull market in equities and underpinned an (albeit sub-par) global economic recovery. Whenever events have flared up that might threaten this recovery (the euro zone crisis, Ukraine, or – repeatedly – Greece) rate expectations have faded, more quantitative easing (QE) has been promised by one central bank or another, and bond markets have rallied. This conveniently offers just enough economic growth to sustain profits, but just enough worry to prevent actual rate rises. It has proved a near perfect tonic for global markets.
What changed over the summer?
Two things appear to have altered the equilibrium in August. First, the spectre of deflation is more worrying for markets than in previous crises, because the sell-off in global commodity prices, Chinese equities and emerging world currencies have all happened simultaneously. This is already impacting global trade volumes and increases the risk of wider economic damage to China, emerging markets and – potentially – the global economy.
Corporate profits have already felt the backlash in the commodity and energy sectors, and there is concern that this could now extend to the industrial and auto sectors (which are already facing the widening VW scandal).
The second concern is that Fed policy this time around has served to confuse rather than comfort investors. Chair Janet Yellen has allowed herself to become hostage to global economic and market events, rather than acknowledge good domestic reasons for finally ‘getting off zero’ and lifting rates. Her perceived dithering is reflected in rising equity market volatility and the extraordinary press speculation on what is, after all, a numerically insignificant increase. It is not only the Fed that has seemed rather flat-footed of late. The Chinese response to its stock market correction has appeared heavy handed, and at times counterproductive.