Equity Storm in a (Bond) Teacup

Last week marked a 3.5% pullback for global equity markets, the first since 2016. The move comes after a very good month, January, during which equities rose to fresh highs, gaining 5.2%, prompted by exuberance related to the US tax reform. However, the arrival of February marked fresh concerns for investors.

First and foremost, economists have noticed a deterioration in global macroeconomic data, especially those published in the second half of January. Macroeconomic volatility, whose dissipation was  a key feature in 2017, resurfaced. US Q4 GDP slowed down more than expected (2.6% below 3% anticipated) and core durable goods orders, a key indication of capital expenditure, was weak for the third month in a row. More importantly, Chinese imports, as well as producer prices, both useful for gauging global demand, were lower. PMI numbers, which are indicative of business’ purchasing intentions,  revealed pressures on the supply chain and some deceleration of growth.

China had a big part to play in last year’s spectacular pick up in demand. Slower Chinese growth could signal to global CEOs that now may not be the best time to expand their operations, and revert to the recent habit of returning earnings to shareholders via share buybacks and dividends. Under this scenario, consumption would not significantly pick up (no expansion means no fundamental pickup in demand for labour).

The second factor is the Federal Reserve, who’s stronger language on inflation and growth, driven by the corporate tax cuts, has made investors realise that it’s consensus opinion, which previously posited 2 rate hikes as opposed to the Fed’s predicted 3, may have to adjust to possibly higher inflation. As a result, ten year yields, previously anchored near 2.4%, shot up to 2.79% as at last Friday, past the critical 2.55% beyond which traders fear a bond bear market. The market has very quickly reached a point where it might test Jay Powell’s, the new Fed Chair, intentions.

What this retrenchment is probably not about, is valuations. Corporate earnings have so far been in line with expectations and valuations are not significantly higher than historical averages.

However, at this point, we need to note that the macroeconomic data has so far been purely circumstantial. It would take at least 6-8 more weeks of choppy data before we could raise a flag about the condition of the global economy. Higher yields have been a specific objective for the Federal Reserve, throughout the recovery, so no one should really be surprised that this is happening. The second point, the Fed’s intentions, is much more important, but it can also be solved with a simple statement from the Fed Chair indicating that accommodative policies will be a priority of the new leadership of the world’s de facto central bank. Right now, this is a storm in a teacup. So long as it remains contained just there, and the Fed understands that the markets are looking for its reassurance, any correction will probably be short-lived, creating opportunities for active managers.