On the face of it, there should be no real surprise that equity market volatility has picked up from those extremely low levels seen over the past few years. Even in isolation, the steady withdrawal of quantitative easing (QE) by central banks across the world would give financial markets pause for thought. The comfort blanket of liquidity that has been there to support asset prices regardless of fundamentals is now seeping away, creating downside risk to equities that has not been seen for years.
Volatility is inevitable
On top of that, liquidity is even being withdrawn by the Federal Reserve in the US, as it winds down its balance sheet as its treasury holdings mature. Even the likes of the European Central Bank have begun to reduce their QE programmes and are likely to begin to reduce their holdings over the next year or two. Given the vast size of central bank intervention, and no precedent to help understand the impact of their attempts to unwind these actions, then volatility is inevitable.
US well into its hiking cycle
On top of this, interest rates are now rising, with the US well into its hiking cycle. This has strengthened the dollar and put pressure on those emerging markets that have borrowed heavily (and cheaply) in dollars but are now facing the twin pressures of weakening currencies and rising interest payments. The likes of Brazil, Turkey and Indonesia have been heavily punished for their transgressions.
1930s style depression
Worse, the US foreign trade policies being threatened could plunge the global economy into a 1930s style depression. Whilst the current level of tariffs that have actually been implemented will probably have a relatively limited negative impact on global growth, they can damage some industrials through higher raw material costs. If tariffs did escalate to the levels that have been suggested then a serious global slowdown, if not recession, is highly likely.
Relatively high asset valuations
Add to this very high levels of debt, ongoing geopolitical tensions, relatively high asset valuations and incessantly negative news flow, then it is hardly surprising that asset market volatility has picked up. In equity markets, those perceived to be most exposed to the above trends have been severely punished, with a shoot first and ask questions later policy.
Emerging market stocks, industrials, basic materials and anything else that is regarded as under threat from tariffs and higher rates have struggled, whilst those expected to be relatively unaffected have continued to perform.
However, whilst it is easy to focus on the potential negatives, the worst scenarios remain relatively remote possibilities and are largely noise for now. If the focus shifts to fundamentals, then for many companies things are looking increasingly rosy, something that the market is choosing to ignore for now but is likely to drive equity performance over the longer term.
Earnings expectations have been rising
Economic growth has accelerated globally from a weather impacted first quarter. In fact, through a combination of rising wages, tax cuts and robust export markets, the US is set to record extremely strong annualised growth in the second quarter and into the second half of the year.
This has been seen in earnings expectations that have been rising strongly across the board in the US, largely because the operating environment that businesses find themselves in is so good. With unemployment at low levels, wage growth is more than likely to continue to rise at rates above inflation, which should boost consumer confidence and spending, which is vital for western economies with such large service sectors.
Beyond the US, China has seen growth stabilise well above 6% a year despite ongoing attempts to bring very high debt levels, built up after the financial crisis, down to more manageable levels. A recently announced fiscal stimulus should reassure that Chinese growth will not drop off a cliff anytime soon.
Europe in much better shape
Even Europe has continued to see a steady, albeit sluggish, economic recovery with the likes of Italy, France and even Greece in much better shape today than they have been for a decade. Falling unemployment from high levels across the EU should also be a great boost to growth. This is clearly being seen through aggregate earnings expectations that have been rising steadily throughout the year. This is an environment that is normally very positive for equity performance.
Whilst negative headlines capture the attention and tend to prompt markets to react emotionally in the short term, fundamentals do tend to be the main driver of performance over the long term. During these periods of higher volatility, assets can get severely mispriced, which means they often offer the best long-term investment opportunities for those brave enough to invest. Focusing on the fundamentals over the noise is often the most rewarding strategy.
Jake Robbins is manager of Premier Global Alpha Growth fund. The views expressed above are his own and should not be taken as investment advice.