The correction that never happened
GLOBAL equity markets have gone without a 5% drawdown for more than a year and they haven’t suffered a 10% correction since the start of 2016. The stock market has powered through several surprise events — Brexit, President Trump’s election, and North Korea’s heightened belligerence — seemingly without missing a beat. How are we to make sense of this unusual trend and how do we prepare for the inevitable pullback?
To take the first question, the enduring equity market rally is being supported by three powerful forces — improving macroeconomic fundamentals, solid corporate earnings and abundant liquidity. Working in tandem, the three factors have provided broad-based support for the market’s stellar performance.
Starting with the macroeconomic backdrop, for the first time since the 2008 financial crisis, the world economy is seeing synchronised growth fuelled by both the Developed Markets as well as the Emerging Markets. This is a seachange from the aftermath of the crisis, when initially the Emerging Markets, propelled by China’s unprecedented fiscal stimulus, and later the US, took turns to support global growth.
Over the past year, we have seen Europe, and increasingly Japan, joining in as global economic engines. Better still, the acceleration in global growth has been accompanied by weakerthan-expected inflation, creating the so-called “Goldilocks” environment — which is positive for risk-taking.
The favorable macroeconomic backdrop has filtered through to corporate profits. For instance, consensus estimates indicate the US, Euro area, Japan and China are all expected to report more than 10% earnings growth this year and over the next 12 months, providing a fundamental support for equities.
And then there is the abundant global liquidity as a result of still- extremely accommodative monetary policies in most Developed Markets ( including the US, despite the Fed raising interest rates). The easy financial conditions worldwide are also reflected in high levels of cash held by institutional investors which have been deployed every time the market has suffered a hiccup. This has acted as a bulwark against deeper corrections over the past year.
So what could unsettle this constructive environment for equities? We believe there are two likely sources of near-term risk:
First, we expect inflation expectations to rise somewhat in the coming months. At some level, this may be reassuring, as it would resurrect the so-called