Divergence silences the music (for a bit!)
The correction in developed markets has alerted market pundits to build arguments whether a decade old bull market has come to an end or not. The combination of higher dollar and yields, deceleration in global activity, tensions with China and outflows from U.S. assets signal caution.
While much of this year’s strength in the global economy has originated from the U.S., so has recent market volatility. From a market perspective, the events and comments from the U.S. over the last two weeks have alerted investors all around. First, U.S. Federal Reserve Chairman Jerome Powell’s remarks sparked expectations of additional rate hikes and Treasuries sold off. Then, U.S. President Donald Trump’s criticisms of Fed actions added to the general confusion in roles against a backdrop of ongoing trade wars and tightening, albeit still accommodative, financial conditions.
Furthermore, upcoming U.S. midterm elections will attract attention to the country. Market participants’ favorable scenario suggests that the Democrats take the House but the Republicans retain the Senate. Under such a divided Congress, the scope for any significant legislation would be limited, and the President would keep his extraordinary powers dealing with trade disputes.
Regarding monetary policy actions in the upcoming period, the Fed is no longer as worried about financial market fragility as it was as recently as early 2016 when the economic fallout from sliding global markets led it to dial back plans to raise interest rates. The economy is healthy, and it is getting a dose of additional stimulus from this year’s tax cuts and government spending increases. The Fed is paying attention to inflation and the jobs market, more than a market correction. The Fed may forgo raising rates again when it meets in December, but that point is probably far below where the market is now. If the Fed decides to go with further increasing rates to stem inflation, it may trigger a selloff in the markets.
Even following the recent correction, the Nasdaq Composite still stayed around 25 percent above the S&P 500 as a multiple of forward earnings compared with its threeyear average of 22 percent. KeyBanc Capital Markets noted that a group of 55 cloud software stocks it tracks were still about 20 percent above their five-year average as a multiple of forward sales.