The last six weeks have seen a marked increase in equity volatility. The sell-off, which started in early October and extended into November, was driven by concerns that both growth and earnings have peaked, alongside risks that trade wars or Federal Reserve (Fed) tightening might precipitate a further deterioration of growth and earnings prospects.
For the most part, volatility has been largely contained to equities, although more recently bond markets have rallied, with long-term interest rates falling about 20 bps from their previous highs in the US. That too suggests markets are anticipating weaker growth in 2019. Foreign exchange markets have been less volatile; partly because there is an expectation the Fed will continue to nudge interest rates higher while other central banks will do little if anything at all. Consequently, the US dollar has remained strong, but confined within ranges.
Looking ahead, we should anticipate continued market volatility. The Fed will continue to hike, even if its normalisation is closer to the end than the beginning. The European Central Bank (ECB) is concluding its asset purchase programme and will shift its attention next year to removing negative interest rates. In Japan, core inflation is continuing to rise. Against expectations, the Bank of Japan (BoJ) may adjust monetary policy in 2019 as well. Shifting and less predictable monetary policies, against the backdrop of weaker growth, will periodically unsettle markets.
A key concern is that as US growth slows, no other major region can replace it as the engine of global activity. In China, credit policy has been eased, but a quick rebound is unlikely. In Europe, growth has been held back recently by special factors, including in the auto sector, but even a pick-up in the final months of this year does not portend a more significant acceleration in 2019. Japan has seen some better data of late, including a rise in industrial production, but as a fully employed economy it cannot generate above-trend growth for long.
In short, post-peak has arrived. That need not imply recession, but it does point to weaker economic growth and hence a deceleration of earnings growth.
Near term, markets may take comfort that the Fed has recently signalled that its policy rates are just below ‘neutral’. Even if the Fed tightens into the early part of 2019, investors may soon discount the end of Fed tightening, typically a positive for risk assets.
For markets to enjoy a stronger recovery, investors will also want to see whether the US and China can resolve their trade conflict. A lasting resolution is probably beyond reach, but some reduction of risk would help markets to recover from the lows reached in recent weeks.