by The absence of deterioration in economic fundamentals suggests that conditions now look ripe for a rebound in equity markets. Equity markets have had their worst start to the year since 1897, following on from bouts of elevated volatility in 2015, and currency markets have also seen major disruption. But elevated market volatility this year was not unexpected and economic fundamentals are little changed. Conditions now look ripe for a rebound. What’s worrying markets? Recent market volatility has four major drivers: Monetary policy running out of steam. The Fed lacks a clear model following the end of QE, which creates uncertainty, and other central banks’ QE is too weak to sustain financial markets. As a result, central banks’ ability to repress financial volatility has decreased. Markets are not yet ready to digest the Fed’s tightening cycle. The fall in commodities' prices. Although lower oil prices benefit consumers, prices have dropped below the threshold (probably around USD40/b) where the negatives in terms of financial disruption start to outweigh the positives. EM currencies have slumped, especially for commodity-producers, creating the risk of a financial crisis (most notably in Brazil). And oil companies’ difficulties have pushed up US high-yield spreads sharply. Concerns about China.
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The absence of deterioration in economic fundamentals suggests that conditions now look ripe for a rebound in equity markets.
Equity markets have had their worst start to the year since 1897, following on from bouts of elevated volatility in 2015, and currency markets have also seen major disruption.
But elevated market volatility this year was not unexpected and economic fundamentals are little changed. Conditions now look ripe for a rebound.
What’s worrying markets? Recent market volatility has four major drivers:
- Monetary policy running out of steam. The Fed lacks a clear model following the end of QE, which creates uncertainty, and other central banks’ QE is too weak to sustain financial markets. As a result, central banks’ ability to repress financial volatility has decreased. Markets are not yet ready to digest the Fed’s tightening cycle.
- The fall in commodities' prices. Although lower oil prices benefit consumers, prices have dropped below the threshold (probably around USD40/b) where the negatives in terms of financial disruption start to outweigh the positives. EM currencies have slumped, especially for commodity-producers, creating the risk of a financial crisis (most notably in Brazil). And oil companies’ difficulties have pushed up US high-yield spreads sharply.
- Concerns about China. The authorities have the capacity to keep economic growth on target, but their management of financial markets has been poor. Moves towards liberalisation of equity and currency markets have proven somewhat messy, with a crash in Chinese equities and considerable pressure on the yuan.
- The strengthening US dollar, which is putting pressure on the US manufacturing sector and emerging-market borrowers in USD.
Little change in fundamentals
But there has been little change in economic fundamentals. The US remains on course for real GDP growth of 2.2% this year, (concerns about a US recession look overblown) and the euro area for growth of 1.8%. Our forecast for real GDP growth of 6.7% in China also remains unchanged.
Recent market disruptions mean risks of a downside scenario for global markets (a major crash) are mounting. This scenario would call for underweighting equities as part of a more defensive stance. However, the absence of deterioration in fundamentals suggests rather that current turmoil on global markets is in line with our core scenario in which solid economic fundamentals continue to support DM equities in 2016.
In this scenario, it would make sense to overweight equities at some stage, in order to profit from a rebound.
Conditions are ripe for a rebound
Indeed, this point may be approaching. Outside of financial crises, the average length of a correction on equity markets is about 50 days—and taking the correction in December as the start of the current period of volatility, the length of this sell-off is now around the average. Since we do not believe that conditions point to a financial crisis, the magnitude and length of the sell-off suggest that we may well have reached the bottom, and are set for a rebound.
In the short term, the ECB’s indication on Friday that it will probably further ease monetary policy as soon as March was likely the catalyst that investors were looking for. However, a sustained rally will depend on the Fed.
Any indication that Fed rate rises will be slowed, or even cancelled, will dampen the dollar’s strength, thus enabling a stabilisation of commodity prices, less tensions in the HY bond market, and an end to the continuous downwards revisions in earnings.