The recent market turbulence is largely fundamental driven. We entered a different era at the beginning of 2018. The turmoil began in early February with concerns about inflation. Some have called this “wage rage” – US wages rising at an accelerating rate, which raised questions about whether inflation might overshoot the Fed’s target and therefore led to doubts about how the Fed might respond.
Although subsequent US inflation data tempered matters, March brought a new set of challenges. Foremost were concerns about trade conflict in the form of US tariffs, the third successive such measure by the US against an array of trading partners. “Trade rage” replaced “wage rage”. But it, too, represents a potential fundamental challenge to markets, insofar as US policy appears to be shifting from decidedly supportive (last year’s tax cuts and deregulation measures) to a less business, more populist tenor. Compounding matters were the Trump administration’s attacks on Amazon, coming at a time of increased concern for the information technology sector regarding data protection.
None of these disturbances is likely to fully recede over the course of 2018. Inflation concerns are likely, at some point, to resurface, given that the economics of the US, the UK, much of western Europe and Japan are all operating at or beyond ‘full employment’. To the extent that bond yields rise further from here based on higher expected inflation, equity markets are likely to experience bouts of weakness and amplified sector rotation.
Similarly, populist rhetoric and policies, for example protectionism, is likely to be a feature of US politics ahead of the mid-term elections in November. Appealing to a base of voters that feels threatened by change — owing to technology or globalisation — will likely remain a key feature of the Trump administration’s political strategy in 2018.
Accordingly, the factors behind the market volatility seen in Q1 2018 are likely to recur. As we have noted on various occasions, the benign conditions of strong market performance accompanied by low volatility, which highlighted last year’s performance, will not endure this year. Falling returns per unit of risk and simultaneous challenges for bonds equities demand a more focused approach to portfolio risk management.
Lastly, there are signs that global growth is peaking. Purchasing manager indices (PMIs) in Europe, the US, and Asia have come off their recent highs. In Europe and the US, that is an overdue normalisation—PMIs had been elevated relative to realised rates of growth and were likely to ‘mean revert’. But more fundamentally, some levelling off of growth is also warranted. As advanced economies use up spare capacity, growth must normalise around its long-term trend. In Asia, the dip in PMIs comes from more moderate levels and may signal some deceleration of global trade, including in commodities.
From an economics perspective, there are few reasons to believe that global growth will slow precipitously. Financial conditions remain broadly accommodative, fiscal stimulus is arriving in the US, business spending is picking up globally and household income remains well supported by jobs growth.
But markets are more sensitive — they price off inflection points. As rates of growth moderate, earnings tend to flatten out, particularly for more cyclically sensitive sectors. To be sure, the Q1 earnings season, now underway, will deliver robust earnings growth (expected around 17% year-on-year for the S&P500), but it is likely to be the peak quarter in year-on-year earnings growth for 2018.
What is the bottom line for investors? As returns moderate and volatility episodes become more frequent, the focus must shift to portfolio risk management. Capital preservation strategies will gain traction. Strategies that deliver incremental return with limited exposure to directional moves in equities and bonds are likely to be in demand, as are flexible approaches to tactical asset allocation.