October's relief rally in equity markets should have provided just that – relief. The trouble is that, with positions washed out, sentiment still fragile and macro data still mixed, few participated fully in the move and many simply didn’t believe in it.
Many commentators – bullish and bearish alike – appear very happy to call for a correction when they feel one is overdue, but nobody likes it when it finally turns up, and sentiment tends to take a lot longer than prices to repair. So what comes next?
Our best guess is an unconvincing grind modestly higher into year-end, with stocks and bond yields slightly higher, commodities still weak and credit providing the best of the returns. The upshot is a continuation of the tempered risk appetite we’ve seen since the summer.
Even if October has some subtext of “woulda, coulda, shoulda”, for the many battered investors who merely watched the rebound from the sidelines, the relative calm has provided welcome pause for reflection.
There are four major factors that multi-asset investors are now weighing: one, the risk of recession in developed markets, which we maintain is still very low; two, liquidity, boosted meaningfully by the dovish remarks from Mario Draghi of the European Central Bank (ECB) and the rate cuts from China; three, emerging market stabilisation, helping to stabilise sentiment more broadly; and four, policy: will the Fed move in December, and does it matter?
GOOD OLD DAYS
Of these four factors, the first is the most important. So what of recession risk?
Most analysts and economists agree that the global financial crisis, in tandem with mounting demographic pressures, has reduced the trend level of US growth. The workout from excessive leverage, the overhang of excess capacity, and the structural drag of an ageing population all contribute to a decline in trend growth. Growth simply isn’t what it used to be. US real GDP growth since the third quarter of 2009 (the first quarter of positive growth after the financial crisis) has averaged 2.2 per cent. By contrast, growth from the third quarter of 1985 to the end of 2007 averaged 3.1 per cent.
Well, here it is folks, the “new normal”. Not much fun, is it? However, to be clear, the US isn’t in recession. Indeed, few if any of the usual recession indicators are anywhere near stressed levels. But it is equally true that the dynamism of an economy that is in mid-cycle on most metrics just isn’t there.
Perhaps this is not surprising. For instance, if we assume wages keep pace with nominal GDP over the long run, then the 2 per cent difference in growth rates pre and post-crisis compounds to a 12 per cent undershoot from 2009 to today. That’s around $5,600 a year by now for a US worker on average annual earnings.
Low energy prices, low mortgage costs and persistently low inflation are all helping to support personal consumption growth, which came in over 3 per cent in each of the last two quarters. But with inventories detracting 1.4 per cent, and net trade flat in the third quarter, the overall picture on US growth remains lacklustre.
Against this backdrop, earnings growth is likely to be positive – if unexciting – in 2016, which should see stocks, on aggregate, drift higher. The upside risk to bond yields is probably limited, even if the Fed does raise rates in December – for bond yields, like equities, a grind upwards looks more likely than a sharp jump.
But for multi-asset investors, there’s always a bull market somewhere. Indeed, the combination of unexciting growth, low risk of US recession, and a dovish trajectory for interest rates is supportive for credit. US high yield offers the potential for equity-like returns.
We do expect sentiment to gradually repair, and we anticipate some more encouraging headline GDP prints as the consumer’s resilience plays through.
Nevertheless, we don’t feel compelled to chase assets today, preferring instead to build exposure in segments such as credit, where valuations are more dislocated from fundamentals than they are in stocks.
As markets stabilise, our mediumterm views will likely prevail once more. But for the time being, we believe a degree of caution is the prudent course.