What do the sharp falls in equity markets across the world port end? Were they simply the inevitable result of prices that had gone up too much in recent months or do they reflect significantly overvalued markets in combination with some sort of material deterioration in the underlying fundamentals? Of course there is also a third option to consider: that economic fundamentals will deteriorate as a direct result of the recent sharp falls in equity markets, the so-called negative wealth effect.
"The lack of activity is not a sign that the likelihood of an eruption has decreased but that pressure is building up underneath"
Looking first at valuations and underlying economic fundamental s, there is nothing on the face of it to be particularly alarmed about. Even before the recent market declines, equity market dividend yields across the spectrum were generally above historic averages. This is encouraging and supportive of a view that markets will soon bounce back: the 2000-2002 and 2007-2009 bear markets began when yields were low in relation to their history. Price to book values too are not stretched. Depending on which market you look at, they are now anywhere between 8 and 30% below historic aver ages. Valuations will not tell you how far markets will fall in the near term – that will be determine d by when the panic stops – but they should provide a guide as to what to expect in the way of returns over the medium term.
As for economic fundamentals, it is certainly true that China has been slowing down and will continue to do so. That there was a material slowdown underway was abundantly clear in declining commodities prices, Chinese electricity consumption and Chinese exports, if not in China’s GDP growth numbers which have declined only slightly from 8% a couple of years ago to 7% currently. China needs to shift away from its one-dimensional investment driven economic growth model to something more balanced. This will certainly be challenging but I suspect will be easier for a com mand economy like China to engineer than would be the case for a more market-oriented one.
In the developed world, final aggregate demand is still weak, but this should if anything be a cause for optimism. Equity bear markets often coincide with declines in the business cycle which themselves occur when economies are operating above capacity i.e. when aggregate demand is strong. Inflationary pressures are also still very subdued which bodes well for central bank policy remaining supportive.
Although Yellen and Carney have both talked about raising interest rates soon, I suspect the likelihood of this happening has declined sharply as a result of the China growth concerns and equity market declines. Furthermore, although unemployment rates have fallen, they remain above (or well above in the case of Europe) levels at which inflation generally starts to rise and central banks tend to act.
So that leaves the two other options: markets falling because they’d gone up too much or a positive feedback loop in which the market falls precipitate an economic slowdown. As to the former, it is certainly true that the global equity bull market that began in early 2009 was well advanced. Furthermore, and more importantly, equity market volatility had noticeably declined.
The VIX index, a measure of equity market volatility had until the last few days averaged 15 since the beginning of 2013 compared with 22 from 2010-2012. Low volatility is analogous to a volcano that has been dormant for a while. The lack of activity is not a sign that the likelihood of an eruption has decreased but that pressure is building up underneath. Furthermore, the longer the period of inactivity the bigger the eruption when it eventually happens.
As for the third option – that turmoil in equity markets causes an economic slowdown – this is much harder to predict. The global economy is a complex system which can often behave non-linearly. Although there will be positive feedback loops that cause household and business confidence to be impacted by the recent equity market falls, there are also negative feedback loops that can cause equity markets to bounce back. Examples of this would be government or central bank stimulus measures or people buying because prices are cheaper.
In summary, it is impossible to say with certainty that we are not about to enter a bear market but from a business cycle and valuation perspective, economies and markets are to varying degrees some way from the point at which bear markets generally begin.
Published in Investment Letter, September 2015
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.