This is late cycle malaise but no bear market

Jonathan Boyd
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This is late cycle malaise but no bear market

Autumn’s storms have blown in new investment dynamics. Volatility has surged across the board, government bond yields are up and equity markets are sliding. We have been reminded that markets have very little capacity to deal with higher interest rates and that corporate earnings growth is going to slow from here. Like it or not, we are facing a synchronised slowdown in growth.

The cumulative effect of successive hikes in US interest rates, while very small in absolute terms, has been enough to trigger caution or a ‘risk-off’ attitude in emerging markets investors already unsettled by Turkey and Argentina’s economic tribulations. This nervousness has been exacerbated by the Italian budget confrontation, which means more uncertainty for European markets already grappling with Brexit negotiations. Even the much over-loved US tech sector has been brought back down to earth.

The dark shadow of trade disputes is cast wide. Protectionism is a lose/lose game: no economy will be exempted from paying its bill in the end. So far, the impact is more visible in slowing global trade growth and in economies that are central to the global ‘value chain’. Europe’s auto industry is particularly vulnerable because of its role in these global value chains. German cars make up a big share of US vehicle exports to China. In Asia the impact of trade disputes on GDP could be significant, although China’s recent fiscal stimulus should help to smooth the initial effects of increased tariffs. In the US,  Trump’s generous fiscal budget means no shadows are visible, yet. But soon we may see downward earnings revisions as businesses absorb new tariffs and wage pressure.

If protectionism becomes structural and goes beyond being an electoral trick, it could really hit the growth outlook. In the short term this should lead central banks to be ‘accommodative’ and not aggressively raise rates. In the medium-term protectionism will have more profound implications. Over the past two decades exposure to large international companies benefitting from globalisation has been investors’ main focus – and this has worked nicely. But this could be upended with investors compelled to seek out industries in individual countries to get exposure to domestic engines of growth.

Taken together these factors add up to higher volatility, but they do not spell a bear market. This is a correction, sure, but the bear market dashboard is not yet flashing red. Market conditions are becoming more challenging: liquidity is eroding, bond yield differentials are widening and real rates are trending higher. But there are no marked areas of excess in the market. Leverage is even decreasing in the US. There are virtually no signs of excess in Europe, although there are some areas to watch in emerging markets. We still aren’t seeing signs of exuberant IPOs. While there is more M&A activity in the US we are not yet seeing this in Europe.

It is too soon to call this an obvious buying opportunity. But investors with an eye to value should watch these areas closely:

  • Europe, once the situation in Italy is resolved;
  • Emerging markets, where the threat from rising interest rates and a strong dollar will dissipate on any signs of a slowdown in the US;
  • US, where investors should come out of overbought sectors (tech) and into the underbought sectors.

In the short term expect to see further downside as risk parity strategies and investors with volatility limits are forced to tune down their risk.

Bond investors should allow themselves the comfort of the classic defensive strategy of buying longer dated core government bonds, in particular, US Treasuries. We believe that interest rates in the US are close to peaking so such a defensive strategy may well turn out to be profitable too.

 

Pascal Blanqué is CIO at Amundi