OpinionApr 3 2018

Understanding the recent market correction

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Understanding the recent market correction
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A lot of investors are clearly baffled by the sharp correction that rocked stockmarkets in early February.

The question we need to ask is whether the turmoil, seen also in US and Asian stockmarkets in early April, demonstrates that markets are hopelessly irrational, panicking just when the real economy is finally showing tangible signs of recovery, when inflation has emerged from the danger zone, and barely a month after a phase of out-and-out market euphoria.

We would argue, rather, that the recent correction actually marks the beginning of a return to rational behaviour, however uncomfortable it may be to investors.

A look back a few years since the 2008 financial crisis may help clarify things.

This was a period of unprecedented intervention by central banks, as heavily indebted governments across the developed world claimed they were powerless to put their economies back in shape. The central bankers' response was to pump cash into the system, and through continuous, massive bond purchases, they pushed interest rates way down. 

The resulting fall in government bond yields drove investors to seek higher returns elsewhere – driving a rally of historic proportions in the corporate bond and equity markets.

What we need to grasp is that the market rally of these past several years involved steering a course between a rock and a hard place.

From 2013 to 2017, for example, the Eurostoxx 600 index gained more than 40 per cent, and yields on German government paper fell by a factor of four, plunging from 2 per cent to 0.5 per cent.

All the while, it didn’t matter much that economic growth was so feeble because of the promise by central bankers that endless cash injections would continue to buoy all asset prices.

And though it may seem counterintuitive, as long as those monetary policies had a lacklustre impact on the real economy, investors could be sure that the central banks would keep coming through – and that valuations would keep rising.

The right question to be asking at that point was what form the process of exiting those exceptional circumstances would take.

If this unconventional monetary policy ultimately failed – that is, if inflation and GDP growth plummeted – financial markets would be shaken by a major crisis of confidence. That negative outcome has not happened.

The other conceivable outcome was success – that economic growth and inflation would pick up as a result of the exceptional monetary stimulus.

But if and when that happened, it would be time to scrap those policies, following which interest rates would rise back to “normal” levels – and equities would accordingly reflect this normalisation. That is what we are witnessing today.

What we need to grasp is that the market rally of these past several years involved steering a course between a rock and a hard place.

The US Federal Reserve was able to stop buying bonds in October 2014 without seriously roiling bond or stockmarkets.

The reason was that both output and inflation were “neither too high nor too low”.

In addition, the European Central Bank initiated its own asset purchase programme a short time later, in 2015.

When the June 2016 Brexit vote sent shockwaves across the financial markets, central banks managed to promptly calm investors by promising to provide whatever support was needed.

And then 2017 gave us the best of all possible worlds. Economic growth was finally on its way up (boosting stock prices in the process), but without a resumption of inflation, which allowed central bankers to go about monetary policy normalisation at a more leisurely pace.

So, the leading central banks are now poised to scale back or even ditch their previous policies. That’s assuredly good news for the economy.

But investors need to realise that the growth drivers they have grown accustomed to are soon to go into reverse. There is no justification anymore for a continuous fall in interest rates.

Central bank intervention had driven them so far down that they were disconnected from economic reality. Interest rates must now move back up to normal levels.

Unfortunately, the Trump administration’s tax cuts have poured fuel on the fire. They will swell the federal budget deficit and force the US government to borrow more – just when the Fed is starting to pull back.

That means there are now two sources of upward pressure on bond yields, before even worrying about inflation.

In Europe, yields on German government paper are quite obviously still far from “normal” levels, even after inching up to 0.75 per cent. 

Financial markets must now revert to realistic prices. Waking from such a pleasant dream will understandably be a new experience.

Once stock and bond prices have overcome the ensuing instability and adjusted to the new reality, investors will need to assure themselves that the economy is still in good enough shape to become the new driver of a stockmarket rally, this time based on sound valuations.

If and when that happens, there might be golden opportunities for getting back in, as we saw after the brutal market correction in October 1987, for example.

However, if the economy were to slow, central banks would have no other option than to apply their recent remedies to restore the markets to good health. Such a U-turn would initially reassure everyone, but it would also amount to a sorry admission of failure.

That is where the real risk lies: if the economy were to still prove too fragile to handle an increase in financial stress, then growth and inflation readings might go into reverse.

We’ll find out only in a few months.

Didier Saint-Georges is managing director and a member of the investment committee at Carmignac