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Are markets heading for a significant correction in 2016?

07 December 2015

Andy Merricks, head of investments at Skerritts Wealth Management, writes how the outlook for markets is becoming increasingly poor at questions whether a significant correction is on the cards next year.

By Andy Merricks,

Skerritts

In just a few short weeks, a number of things have happened to make it even more difficult than usual to forecast what to expect in the coming weeks.

The Paris attacks, the downing of the Russian warplane, the ECB announcement on 3rd December and the forthcoming Fed announcement due on the 16th December all have implications of varying degrees on how 2016 is shaping up…and it doesn’t look too pretty.

Performance of index over 1 month

 

Source: FE Analytics  

Normally we can predict with a fair amount of confidence that the final month of the year and the first few weeks of the next will translate into an investor-friendly rally which, if you are sitting on the sidelines, will normally hurt your overall annual return should you miss it.

The ‘Santa Rally’, as it has become known, has been as predictable in its timing as the X-Factor Final. It is the use of that word “normally” that gives us a clue as to the uncertainty that we’re seeing though.

What is normal any more?

 

The ECB’s Peashooter

It is fair to say that markets were expecting Mario Draghi to give QE a double-barrelled blast in early December.

Instead of his shotgun he delivered with his peashooter. Markets reacted badly to the disappointingly restrained level of action – equities slumped and the Euro rose – but is this the first sign that Draghi’s superpowers are on the wane?

Maybe there’s just not that much that central bankers can do any longer. It could possibly be that the Paris attacks have had more of an effect than we’d normally expect.

Normally, terrible as they are, terrorist attacks have little or no lasting effect on markets, but the ECB is dependent upon the political will of the EU to support its actions. After Paris it can be expected that sentiment in Europe may shift to the right, and many on the right (especially in France) would like to see the single currency dismantled.

Then again, it may be that the ECB’s mandate is too restrictive.

Draghi has said that, “we have a mandate, and the only responsibility we feel is if we are not able to comply with our mandate.”

What is this mandate? It is to keep inflation rates below, but close to, 2 per cent. Despite early predictions to the contrary, the extraordinary global monetary easing policies have been anything but inflationary – of course, normally they would be – and as Ben Bernanke said:  “people react to what they see, not what they are told.”

Central bankers may promise, and indeed try their best, to halt the slide into deflation, but confidence in their ability to do so has all but evaporated.  What’s more, if you become too focused upon too narrow an objective, you can miss what is going on in the wider picture. Which brings us to the Fed.

 


 

Stop looking behind you

We’ve said this before, but we think it is worth repeating….when rates are raised on December 16th (as surely they will, in our opinion) in the US, there is every chance that it will become clear in hindsight to have been a policy error.

It won’t surprise us at all if discussion turns from the current “how high will they go” to “how soon will they come down again” as we progress through 2016.

Many people expect markets to react positively to a rate increase, more in relief that the interminable speculation over whether they will go up or not is over than for any fundamental reasons, although there are those who will point to the fact that Janet Yellen has had the confidence to raise rates for the first time since 2006 as a sign that this confidence is reflected in her view of the strengthening US economy.

But herein lies the biggest problem.

The Fed is transfixed upon unemployment data which is a consequence of the previous 6 months’ data. What they should be doing is looking forwards, not behind them, and if they looked ahead they’d see that all the leading indicators of credit, new orders and unfilled orders have turned negative, indicating a slowing economy rather than a strengthening one.

If the real reason for raising rates is so that there is a weapon in the armoury for any future bad news then we could be heading for trouble.

This would imply that, in reality, Janet Yellen knows that the economy is worsening but she is willing to risk a market sell-off now in favour of waiting for markets to respond to weakening data in a more natural way in 2016, during which time she can deliver a calming tonic by way of a rate cut should it become necessary.

 

On thin ice

Basically, it seems that the world is skating on thin ice at the moment.

Peter Berezin of BCA Research uses the analogy of the leaves on a tree. In Summer, with the tree healthy and strong, even a hurricane will not cause the leaves on the tree to fall. However, as Autumn approaches, even a brisk wind can lead to most of the leaves coming down in droves.

It doesn’t feel as though it would take much of a storm to strip the leaves from the investment tree at the moment, but probably not just yet.

It feels as though we are vulnerable to a shock, but has this been tested by Paris or the Russian jet?

Will another Paris-style attack cause more jitters or will we become collectively somewhat desensitised the more common these attacks take place, as we did during the last bull market in terror in the 70s and 80s, during the reign of the IRA, Bader Meinhoff, ETA and events such as the Munich Olympics?

From a market perspective we feel that there is far more likelihood of a major correction occurring for no particular reason other than the realisation that the central bankers are out of ammo and there is no one to ride to the rescue when things turn economically ugly.


 

We’ve used the word groupthink before and it is this that may turn the latter stage bull market into an early stage bear.

Performance of index since the global financial crisis

 

Source: FE Analytics

Groupthink occurs when everyone shares an opinion. Markets are healthy when there is a difference of opinion as someone with an opposing view will buy from the other party that disagrees. If short term investors agree with longer term investors they will buy the same thing.

When one or other changes their mind and wants to sell, there won’t be anyone to sell to unless the price is adjusted more dramatically than normal. If everyone changes their mind together then you don’t want to be playing at that time.

Whether a change in interest rate cycles, or a realisation that a slowing global economy will lead to potentially more profit warnings and earnings disappointments, will lead to groupthink changing direction, we will have to wait and see. 

It will be increasingly important to keep part of your portfolio in that sector labelled ‘safe haven’ but the fun will start when these safe havens become nothing of the sort as opinions adjust.

2016 promises to be a lively year in more ways than one. May it be a healthy and prosperous one for you.

 

Andy Merricks is head of investments at Skerritts Wealth Management. All the views expressed above are his own and should not be taken as investment advice. 

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