IT is easy to panic and believe that a bear is lurking around the corner, judging by the sensational headlines and huge downward spiral of the Dow Jones and global markets.
After nine years of expansion following the 2008 recession, investors finally realised that the long smooth ride is over. This week’s volatility can drive even the most sensible of investors to make bad short-term decisions.
This is futher magnified by the relatively “peaceful” 2017 investors had enjoyed – the Dow barely saw a single-day drop of 2%. The last time there was a big fall was back in January 2016 when it lost 8.33% over a course of one month. Since last Friday, the Dow is down some 11%.
The S&P 500 fell by 4.1% on Monday and 3.8% on Thursday. It experienced a sharp correction in January 2016, when it slid by 13.3% on concerns of falling oil prices.
The steady uptrend of the markets in 2017 was the new calm that preceeded markets.
Thus, not surprisingly, when the Dow fell last Friday, it rankled the psyche of investors. Many instinctively viewed it as a potential carnage.
The FBM KLCI, along with the rest of the global markets, was not spared. For the week, the local index was down 2.7% at 1,819 points, but was still up 1.28% on a year-to-date basis.
So, what are the markets trying to tell us?
In a way, this correction has been much-awaited.
The biggest difference now, when the S&P saw a correction of more than 10%, is that the slide coincided with positive economic data.
As for the reason for this week’s tumble, the main culprit appears to be higher wages in the US bringing about higher inflation, and thus, clobbering global markets.
Bond investors have also been pricing in higher inflation, and thus, bond yields were spiking.
While markets tend to show fundamental trends over the long-term, in the short-term, they are just a mixture of emotion, information and noise.
Stocks will rise over the long term, but what happens in between is the erratic ups and downs. These are goaded by the “noise” of business or political news, geopolitical tensions, charts forecasting downtrends and nervous investors monitoring their stocks by the minute.
It is hard to see a trend forming over one week, and most likely, the market’s fall is not an indication of something ominous.
Over the last few decades, a two-digit drop typically happens every 18 months or so.
The bull market in the United States has been up some 300% since March 2009 and in that period, the market has witnessed corrections five times, including the one that happened this week. In 2015 and 2016, the sharp falls were due to fears of oil prices slumping.
In August 2011, the 19.4% drop in the S&P was due to fears of contagion of the European sovereign debt crisis, especially in Spain and Italy.
Subsequently, the markets recovered and eventually moved higher.
“For all you know, it could just be one big fund in New York deciding it was a good day to sell because it had made fat profits. That profit-taking caused a herd mentality and other funds panicked and the selling madness started. Suddenly, boom – people are saying a recession is happening,” says MIDF Amanah Investment director of corporate investment banking Sherilyn Foong.
“The pullback is much anticipated, as, to a certain extent, markets have been on a tear for a long time... ours less so, but still positive nonetheless. The severity of the decline was a surprise, not so much the decline,” says Ching Weng Jin, head of research, Public Investment Bank.
“Fundamentals are unchanged. Global growth is stronger, and the earnings picture has improved,” he says.
Retirement Fund Inc director and head of equity department Taufiq Iskandar Jamingan says sentiment shifts are taking place where a repricing of risk is occuring.
“Within the equity space, active investing has taken a backseat in recent years to passive investing, and this has a tendency to accumulate stocks and drive up momentum.
“Investment products such as exchange traded funds as well as leveraged quant strategies that bet on volatility and risk parity have also gained popularity.
“Thus, the downdraft in equity markets was further magnified by an unwinding of crowded trades betting on rising momentum and low equity volatility,” says Taufiq.
Interestingly, the sharp volatility spike has not spread to other assets such as credit and currencies, he says. The bond markets have also stabilised, and investors need to see US Treasury rates staying above the mid-3% level before there is a clear negative correlation to equity markets.
Stock market backed by solid fundamentals
The investment fraternity isn’t unduly worried about global markets falling, as generally, the health of the world economy is at one of its best phases.
“After having gone through a few painful bear market cycles, this week’s sharp sell-down isn’t that bad – it was swift followed by an immediate stabilisation instead of prolonged pain from many sessions of sell-downs, which would then be aggravated by margin calls. Hopefully, this remains a swift correction amid the positive global recovery growth data. The increased volatility provides more trading opportunities,” says Foong.
She adds that under such volatile market conditions, it is important to stay disciplined and not let emotions rule.
Social Security Organisation chief investment officer Dr Suzana Idayu Wati Osman says the defensive local market has fared relatively well, as the FBM KLCI has only dropped some 3% from the recent peak of 1,875 at the beginning of the month.
“Generally, any correction below 10% might provide investors with attractive valuation opportunities to add to their core positions. We remain positive on our equity market.”
Ching says that this pullback is a good reminder to be more vigilant, and that markets aren’t entirely a bed of roses.
“Given the heightened volatility, we should probably adopt a trading stance, if there were significant dips, we would suggest stronger accumulation,” says Ching.
Meanwhile, Affin Hwang Asset Management senior portfolio manager Huang Juin Hao says indicators do not point to a bear market, as the broader fundamentals have not shifted.
“The synchronised global growth trajectory remains intact, and commodity-led inflation remains largely a product of managed supply controls. The ongoing corporate earnings reporting continues to see upside surprises, providing fundamental support for forward earnings upgrades and equity valuations.”
He says the strong performance of the equity markets in 2017 and in January has left a lot of headroom for profit-taking and investors to lock in gains.
“The upcoming Lunar New Year season will also see some markets in the region close for the festive season and add to the selling pressure.
“It’s not uncommon for investors to reduce their risk asset exposure prior to the holidays, and these factors could partly explain the sharp movement in markets,” he says.
Huang says that given the strong run-up in the early part of the year, a correction should have been widely expected.
Investors have taken the turn in sentiment as an opportunity to lock in some gains and will be taking advantage of the correction to re-position at a cheaper entry level.
“We believe the current correction is driven by near-term factors and remain positive on the medium-term fundamentals which would be supportive of the market,” he says.
On a more positive note, Taufiq says that as the country gears up for the next general election, he expects a robust domestic equity market and for liquidity to be more vibrant.
“The elections will dominate local sentiment and dictate market direction in the first quarter of the year. The rising bouts of volatility in the local market should be embraced and barring any upsets, equities are expected to play catch-up this year with regional peers after being a laggard in 2017,” says Taufiq.
Suzana says that the elections may cause volatility, but once they are over, there will be a clear direction on policy continuity.
“So far, the correction is not due to election volatility, but driven by global investor sentiment. I believe that the global market risk is of far greater importance compared with idiosyncratic political risk. Generally, the market is forward-thinking and would have priced in any political risk factors in its current valuations,” says Suzana.
Strong US economy
The US market is stronger than ever and this was evident in the job figures released last Friday. The Labour Department reported that the added a robust 200,000 jobs in January.
Businesses are hiring, and this can drive the unemployment rate – already at a 17-year low of 4.1% – even lower.
Consumer spending, which is the primary fuel of the US economy, increased 3.8% in the fourth quarter of 2017 to US$12.028 trillion. That is the fastest pace in a year and a half. Americans are growing more optimistic about the economy, and therefore are spending more.
Businesses are buying more computers, machinery and other equipment. Such purchases increased faster in the second half of last year than in any six-month period since 2014. Companies typically accelerate their investments when they foresee an improving economy.
Topping it off, the US economy has something supporting it that it hasn’t had for nearly a decade – sturdy growth around the world.
Roughly 120 countries experienced faster growth in 2017 compared with 2016, according to the International Monetary Fund. That’s the most since 2010, and this also tends to benefit the US economy.
As with housing, consumer confidence is solid, and manufacturing is rebounding. Households and businesses are spending freely. Personal debt has lightened since the financial crisis a decade ago. And major economies around the world are growing in tandem. The bond market, which is largely driven by expectations for future economic growth and its impact on the interest rate outlook, is also looking optimistic, with prices suggesting that there should be continued growth moving forward.
Last Friday, the yield on the 10-year treasury spiked from 2.4% to 2.8%, suggesting bond investors’ confidence that the current steady recovery will allow the Federal Reserve (Fed) to raise interest rates gradually.
The relationship between the stock market and interest rates
Over the last two decades, the has kept the fed funds rate between 2% and 5%.
The common narrative is that rising interest rates are a headwind for stock market prosperity. This is because in theory, investors will move their money out of the stock market and put it in higher-yielding instruments.
Ching adds that the only thing that has changed are expectations this round, of higher inflation and higher rates, which could then hurt growth.
“Not a wrong expectation, but if we take a look back at the last time the US hiked rates, growth didn’t show any worse for wear.”
Truth be told though, interest rates and the stock market typically move in the same direction over a period.
This is because the criteria that leads to a rate hike, such as an expanding and recovering economic growth, also fuels bull markets.
Meanwhile, rate cuts are normally driven by recessions, which lead to bear markets. So, stocks and the economy aren’t going to face destruction despite the rate hikes.
Fisher Investments MarketMinder says that short-term interest rates on their own aren’t a market driver or hugely meaningful for the economy.
What really matters is the yield curve spread – which is the gap between short-term and long-term rates. Short-term rates represent banks’ funding costs. Long-term bond yields are the reference rate for banks’ lending rates, a proxy for their revenues.
“The gap between them – long rates minus short rates – represents banks’ profit on the next loan made,” says Fisher.
Wider spreads encourage more lending, adding fuel to the economy, while negative spreads usually choke lending and precede recessions. Hence, determining whether a rate hike will harm the economy requires looking at its potential impact on the yield curve. Investors historically have viewed the shape of the yield curve as a signal of future growth.
For the uninitiated, the yield curve compares interest rates at different maturities, typically the spread between yields on two- and 10-year bonds. Ten-year yields historically have reflected the market’s growth and inflation outlook, while the short end of the curve is mainly tied to market expectations for policy rates.
The yield curve flattened for much of 2017, primarily due to a rise in short-term yields. While a flattening yield curve can signal slower growth, rising short-term yields in 2017 showed greater market confidence in the growth and inflation outlook, which also carries expectations the Fed will continue to normalise policy rates.