The past six months have demonstrated just how fragile investors’ confidence in the economic outlook has become, shown by how quickly markets can drop by 20 per cent and then rebound, according to Columbia Threadneedle’s William Davies.
Davies, who is the asset management house’s global head of equities, believes that the stock market plunge in the final quarter of 2018 and powerful recovery that followed in 2019’s opening three months were not an illogical series of events, but rather “tells a coherent story about the fragility of investor confidence as we navigate the end of this economic cycle and approach the US elections in 2020”.
Global markets suffered a significant downturn at the end of 2018 as volatility returned. Major equity markets dropped around 17 per cent before bottoming out on Christmas Eve, Davies noted.
Performance of indices in Q4 2018 and Q1 2019 (in US dollars)
Source: FE Analytics
This was followed by a sharp rebound, with global equities climbing 18 per cent between December and March. But the investors does not believe this rally signals a dangerous complacency settling in amongst investors about the risks for the forthcoming year.
“The severity of the sell-off during Q4 may have been unexpected but it is explicable, given the background and some of the data that was being released. I also believe the rebound at the beginning of this year is justifiable, even if I have been surprised by the degree of its strength,” he explained.
“Both the sell-off and rebound were reactions to a range of rapidly shifting geopolitical risks – especially tensions over Sino-US trade – that investors find increasingly difficult to predict and price in. With confidence brittle and events at times moving quickly, markets may have oscillated more violently than usual, but their reactions were not irrational.”
Investors tend to look for both political and economic stability but this was majorly disrupted in 2018 by two main political tensions, according to Davies, which caused investor confidence to decrease in the fourth quarter.
The first tension he highlighted was a group of nationalist strongmen being in charge of major global economies, highlighting leaders such as the US’ Donald Trump (“a domineering and unpredictable figure”), China’s Xi Jinping, India’s Narendra Modi, Japan’s Shinzo Abe, Brazil’s Jair Bolsonaro and Russia’s Vladimir Putin as examples.
“The world has therefore entered a phase in which a strong-willed US president is prepared to argue forcefully that his country’s relations with the world should be reset, but must pursue his claims against a group of increasingly assertive and populist leaders in other countries,” Davies explained. “This is not a recipe for calm and stability in world markets.”
Trade tensions are the second factor he noted. The impact of these more volatile political agendas combined with the diminishing trade relations between the US and China has, in Davies’ opinion, made the nervousness of investors understandable when the threat to stability and potential market slowdown was palpable.
The US-China trade war took another step away from reconciliation this month after Trump announced a tariff increase on $200bn of Chinese goods, only for China to respond by hitting $60bn of US goods with tariffs.
The uncertainty of investors is therefore an understandable consequence of the capricious nature of global geopolitics; uncertainty which played out on the global market where investors had become increasingly concerned about the high equity market valuations coming at the end of the cycle, making them alert to a recession many have believe will be coming soon.
However, Davies considers the sell-off and following rally to be justified but said the strength of the upswing in world markets looks “surprising”. That said, he thinks markets should be higher than they were at Christmas because the outlook is “not as dire as had been feared”.
Even after the rally, the investor argued that current valuations for major equity markets do not look expensive when compared with their earnings forecasts and said that there appears to be room for valuations to rise.
“All this suggests that while the rapid decline and rebound in world markets over the past six months or so was justifiable on the basis of the geopolitical backdrop and a spell of softer economic data, the current economic cycle has further to run. A mini-cycle did not turn into a major downturn... this time,” Davies concluded.
“However, alarm bells are ringing. This is primarily due to the current fragility of the relationships between the world’s large economic blocs and the unpredictability of negotiations between powerful, nationalistic world leaders.
“The highly unusual events of the past six months demonstrate how fragile confidence in the economic outlook has become – and how quickly markets can drop 20 per cent or indeed rebound. The worst outcome did not happen and my central case is that growth will continue until late 2020 and earnings will increase further before we reach the end of this cycle.
“When that moment arrives there is no way of knowing whether we will enter a major downturn or simply a relatively short period of slower growth before the economy picks up. But the biggest question for investors everywhere will in any case be the same: when the next downturn does eventually take hold, how much room for manoeuvre will central banks and governments have to protect and stimulate their economies?”