It has been a tough first quarter for investors. We have seen a phase of episodic volatility in markets, driven by growth worries.
High levels of correlation within risky assets has meant that navigating the environment has been difficult. Market concerns in January and February centred around three key macro issues.
First, market participants became increasingly concerned about a manufacturing-led US recession. Second, there was a reflexive tendency among investors to infer a growth signal from weak financial prices in other asset classes (the falling oil price, plummeting bond yields, weak shipping indices). Third, there was heightened uncertainty around the outlook for China and especially the policy agenda.
Yet since the equity market lows in February, risky asset classes have roared back strongly through March. Market pricing has dramatically moved on from embedding recession risks in February, to now discounting an improved economic picture.
What drove this volte face?
Partly, the expectations of weaker growth were not well calibrated assessments of the future. But, also, it was policy; aggressive easing measures from the Bank of Japan and ECB, as well as a clarification on China’s currency policy and a renewed emphasis on fiscal support following the G20 summit.
The Fed did their bit too, by passing on the option to raise rates in early March and providing very dovish forward guidance.
So how should we understand all of this?
Most importantly, it reinforces the view that there is a huge amount of noise in financial markets. More often than not, market volatility is an excessively sensitive reaction to adverse news-flow. As such, making sense of the market environment requires a discipline around valuations and a clear, structured analysis of economic risks.
In the early part of this year market pricing was beginning to reflect the notion that there would be a meaningful shortfall of aggregate demand relative to supply, and that nominal growth would be so weak that corporate fundamentals would be undermined.
But despite the suggestion of many analysts that central bankers were “out of ammunition”, policymakers were able to provide a cushion.
So where does this leave us today?
We are in a “fragile equilibrium”. The global macro environment remains one of lacklustre growth, but there is no inflation psychology. In fact, despite the market turmoil, the cyclical outlook remains broadly unchanged, though growth expectations have been revised down somewhat.
However, economic momentum has actually improved a little in the US and in emerging markets. Oil prices have stabilised, and deflation fears have receded. Significantly, however, an important result of the recent market turmoil, and a recurring feature of this cycle, is that the market’s assumption of “lower for longer” interest rates has now become one of “lower for even longer”.