Money Matters

History has some troubling lessons on bear markets

Money Matters
By Michael Mackenzie
Mon, 01, 19

Trying to predict markets is a perilous task at the best of times. That certainly appears the case now, given the hangover investment funds are nursing after the pain inflicted in 2018 across bonds and equities, the twin pillars of portfolios.

Trying to predict markets is a perilous task at the best of times. That certainly appears the case now, given the hangover investment funds are nursing after the pain inflicted in 2018 across bonds and equities, the twin pillars of portfolios.

At this stage of an ageing economic cycle, investors have good reason for concern as they try to work out whether the rout in equity and credit markets represents a final correction in this cycle or the start of lengthy decline. We have not begun a new year in such a glum mood since the start of 2009 and before that, 1999.

Two important developments in US markets illustrate the dilemma facing investors. Wall Street’s bruising run means the earnings multiple for the S&P 500 has fallen sharply from its peak in late 2017, typically a harbinger of strong returns for the coming year. Any positive surprises in economic data and corporate earnings will buoy sentiment alongside lower oil prices.

But casting a lengthy shadow is a US Treasury yield curve that has begun inverting — the 12-month bill yield is now higher than those on all Treasury maturities out to seven years. This is typically a signal that the Federal Reserve has tightened policy too far and that a recession loiters beyond the horizon.

As this tense game of market chicken between equities and government bonds unfolds, plenty of the macro outlooks released for 2019 exude the confidence that the global economy will remain firmly in expansion mode, albeit more slowly than 2018. The common view is that recession risk appears low, so worrying signs of contraction in Japan and Europe should reverse.

Concerted stimulus from Beijing that would benefit these economies, as well as emerging markets, is on an investor wishlist that includes an easing in US-Sino trade tensions and, above all, a pause from the Fed in its monetary tightening. Jay Powell insisted on Friday that the central bank would be patient in assessing the economy.

This wish list is not an unreasonable one for 2019 and indeed this week’s grim start increases the chance of such an outcome. Sliding equity prices, with Apple’s revenue warning this week partly reflecting weaker demand from China, is something that neither Washington or Beijing wants to see more of. As for the central bank, the likelihood of a pause is supported given US credit risk premiums at a two-year high and equities are trading at well below less Icarus-like heights, which has tamed some financial excess.

Whether these catalysts can staunch the bearish investment sentiment could yet prove the big surprise for markets and investors this year.

Let’s not forget that to varying degrees central banks are withdrawing their support, something a turn in the calendar year does nothing to change. The prospect of further deleveraging by investors is casting a lengthy shadow and that comes as financial markets are reminding everyone of their importance after a decade of easy money.

Investors must also be mindful that the punishment meted out to portfolios over the past 12 months begins to filter into the broader economy, sapping business and consumer confidence, as highlighted by this week’s release showing December had much weaker than expected US manufacturing activity. That fear was tempered somewhat by the much stronger than expected US jobs reported released on Friday, underlining the tricky task facing investors and the Fed.

The importance of asset markets to the US economy is highlighted by the fact that the level of total financial assets as a share of gross domestic product has climbed to a record. As Joe Lavorgna at Natixis notes: “Before each of the last two downturns, this ratio peaked and fell just before the onset of recession.”

Another interesting gauge comes via Miller Tabak’s look at non-financial corporate debt, which in their view has “declined significantly” since the second quarter of last year. This drop does not solely reflect higher US interest rates and they warn that “reduced business investment typically foreshadows declining household consumption as economic conditions decline”.

For all the probability of a relief bounce at some point this year, investors should realise this most likely represents a limited trading opportunity. That wariness is reinforced by how December unfolded, with the market fear trade arriving at least 12 months too early for many who see the higher recession risk in 2020 rather than 2019.

For all the advocates that we are currently in a late-cycle correction, the clear message from the market is that the sands are running out on this cycle. And a troubling history lesson from early 2001 and late 2007 is that even when central banks start easing policy, it doesn’t stem savage bear markets.