The troubling spectre haunting markets
One raging storm is enough for investors. But two in one week is especially scary. The shrieks and moans of the Brexit storm are wearisomely familiar. How much more of this can we take? And while the chronic uncertainty of the Brexit outcome has morphed into constitutional stand-off and the potential downfall of the Prime Minister, we have not – or not yet – had the full-blown Brexit sell-off that many have been predicting.
More worrying, however, is the unfolding storm in the background: the prospect of a worldwide stock market sell-off heralding a global economic downturn and the US and major European economies sliding into recession.
These were the black clouds that descended on markets last week. Over a deeply unsettling five days the FTSE 100 fell 202 points, or 2.9 per cent, to 6,778, down 14 per cent from its all-time high and wiping out all the gains of the past 12 months. The FTSE 250, largely comprising Uk-focused firms, fared worse, losing 3.4 per cent. The UK was far from alone. The German DAX lost 4.2 per cent, the French CAC 40 was down 3.8 per cent and the Tokyo Nikkei dropped 3 per cent. But the worst of the bloodletting was in the US, where the Dow Jones tumbled 1,149 points, or 4.5 per cent. And the Nasdaq, largely dominated by tech stocks, lost 4.9 per cent.
Nor have the bond markets fared any better. How could investors in the US, where the economy has been powering ahead this year, suddenly become so apprehensive about their stock market investments?
Blame it on the inverted yield curve, say the pundits. Apprehension has centred on a closely watched bond market measure which, they say, has predicted every downturn for the past four decades – although it has also triggered false alarms.
So what is this measure? Normally yields on government bonds are straightforward and upward-sloping – lower yields offered on short-dated bonds, with yields rising with the length of the bond, reflecting the greater risk investors take on by buying a bond with a 12- to 15-year maturity.
But that’s not what we are seeing. Last week the yield on five-year US government bonds fell below that on shorter-dated debt – the so-called inverted yield curve. This is seen as a warning of a slowdown and recession over the next two years – one that portends tighter financial conditions and weaker confidence. This is the troubling spectre haunting markets.
David Page, a senior economist at Axa Investment Managers, said the inverted yield curve “has proved a very reliable yardstick for a significant downturn in the past, and we think it will do again”.
Similar concerns are evident at research group Crossborder Capital. It noted that global liquidity conditions “have been hammered lower” over the past 15 months, due to central banks – especially the US Federal Reserve – substantially shrinking their balance sheets as they ease back on the emergency measures put in place after the global financial crisis.
These low liquidity conditions also help explain that rate curve inversion: the shift of insurance companies, pension funds, banks and the like into the safety of long-term bonds, thereby forcing down their yields.
But an all-out US recession? That seems scarcely credible, given the strength and momentum of the US economy over the past 12 months. It has been growing at an annual rate of 3 per cent, unemployment remains low, inflation is well below the Fed’s target of 2 per cent. Business confidence is strong and consumer spending continues at a high level.
But there are signs of a slowdown. Recent survey data suggests a weaker growth pace next year, the housing market remains weak and the rate of consumer spending cannot be sustained without a rise in personal incomes.
Inverted yield curve apart, what is also worrying investors is not so much the underlying economic picture but uncertainty over trade, fiscal and monetary policy. On trade in particular, it is hard to discern whether President Donald Trump, pictured, is in favour of trade tariffs and sanctions against China or has softened his hawkish pronouncements. It is this uncertainty that has fuelled market volatility – now aggravated by algorithmic selling – equivalent to some 80 per cent of the market.
No one wants to be left dangling on an inverted yield curve. And given this heightened volatility, investors may wish to trim their holdings to reflect a change their risk tolerance. But a total bailout? Almost certainly not if you are a long-term investor. A well-balanced equity portfolio should also be providing dividend income. And the coming 12 months are almost certain to provide buying opportunities.