Stop the press early February update – The correction we had to have?
For every month in 2017 there was a positive return for US shares that in aggregate saw the market advance by 22%. It is rare to see such a long and unbroken sequence of positive monthly returns for shares. Buoyed by a long and steady diet of easy liquidity, the market had become very complacent about risk. As mentioned on several occasions last year, we had been expecting a pullback at some stage to be used as a buying opportunity. The excessive optimism in early 2018 resulted in a “melt-up” in share prices, so it was not unexpected to see the market correct, although the severity of the fall was a surprise. US shares fell by almost 10% in just three trading days with other global markets including Australia following in lock step.
Despite the severity of the falls, the market has only retraced its steps to where it was in late November 2017. The catalyst for the correction was the release of US employment data that showed wages growth marginally stronger than expected, rising at an annual rate of 2.9% compared to 2.7% the previous month but representing the 4th consecutive monthly increase. This raised the prospect that wages growth may push inflation higher forcing the US Federal Reserve to accelerate their timetable for higher interest rates in 2018. In anticipation of this, bond yields have crept higher with US 10-year bond yields up some 43bp so far this year and Australian bonds up 25bp. The weakness in the USD over the past year, has also led to higher import prices while somewhat offsetting the monetary impact of the tighter interest rate settings imposed by the Fed. The likelihood of a short term blow out in the US budget deficit following the tax cuts has also put further upward pressure on bond yields.
A technical correction or a bear market in shares?
The prospect of higher interest rates as a consequence of stronger growth is no surprise to the market and has been anticipated for some time. The question the market is grappling with is the pace at which the Fed will move to stay ahead of the inflation curve and establish a more normal interest rate setting. This uncertainty is prompting the market to recalibrate its previous expectation of measured incremental rate rises to something more significant. Generally speaking, the higher bond rates move the lower the multiple of company earnings investors are prepared to pay and therefore share prices tend to fall.
On the positive side, it is worth remembering that the reason behind the inflation and interest rate concerns is that economic growth is accelerating on a synchronised basis around the world. While early signs of inflation from stronger wages are starting to emerge in the US, there is little sign of inflation elsewhere in the world with Europe and Japan maintaining very easy monetary settings to actually encourage higher inflation. As a consequence, corporate profits are booming with forward expectations undergoing positive revisions which will be a powerful driver of share prices over the medium term. In the US, early results from the December quarter profit-reporting season are pointing to profit growth of around 15%. It is very rare for share prices to fall consistently against a backdrop of strongly growing profits. While in the past few years, share prices were boosted by P/E expansion from easy liquidity, going forward earnings growth will be the primary market driver. It is also highly unlikely that the global economy is moving towards a recession anytime soon especially given that other major economies are well behind the US in their recovery cycle.
The cornerstone of our investment philosophy is to maintain a focus on medium-term fundamentals and avoid being swept up in the short-term noise created by extreme swings in sentiment. Remember the old adage that in times like this, stocks tend to move from “weak hands to strong hands.” Notwithstanding the sharp price adjustment we have seen, the medium-term outlook for stronger profit growth will be positive for shares and should more than offset the negative impact of reduced monetary accommodation. Therefore, we remain of the view that the outlook for shares remains sound and should still provide superior returns to most other asset class alternatives. If the negative sentiment and technical selling result in further significant falls, we will look to add to positions in Australian and International shares. With the likelihood of more volatility for the remainder of 2018, we are also considering a number of diversification strategies for multi-asset portfolios that will benefit from the stronger anticipated economic outlook.