Market Volatility: This dance we have danced before (and shall again)

Tue 06 Aug 2019

Financial market turmoil continues for the second straight week, plunging the S&P 500 close up to 7% from its peak, in a bout of volatility similar to last December’s.

The reasons behind the recent tumult are rather straightforward:

1) A stock re-rating, after Fed Chair Powell last week suggested that the central bank is not entering a rate cut cycle, but would rather make “adjustments”.

2) The escalation of the US-China Trade War. After Donald Trump slapped 10% fresh tariffs on $300 billion Chinese products, Beijing responded by letting the Yuan slide to more than 7 vs the Dollar. The US President then labelled Beijing a “currency manipulator”.

Primarily investors need to understand that the two reasons are intertwined. All risks, in fact, are concomitant with item (1), the Fed’s stance. We have long noted that market expectations on rate cuts were unrealistic, at least at this point. It was inevitable that the US -and the world’s de facto- central bank would let traders down, as it does not have any plausible reason to slash interest rates 3-4 times this year. Even if they did, markets would then expect more. When the Fed is hawkish, or at least more hawkish than markets want, then other risks, which might have successful stayed in the background, surface. Had the US President succeeded in cajoling Powell to cut aggressively he would have both had a backstop against a Yuan slide (a weaker Dollar) and a low-volatility environment within which he could escalate his trade attacks without significant market backlash.

Should investors be concerned?

We don’t believe this is the case yet. Economic fundamentals are weak, to be sure, as the Chinese slowdown continues to affect global growth, and earnings in the US are flat. However, there’s still a modicum of growth and valuations (US stock P/E is 17.2, down from over 18) fully support current index levels. The situation looks very similar to last December’s, when markets melted down during a holiday period of low volumes on Fed hawkishness.

First, August can be a volatile month, but September, with more humans manning the desks now run by computers, is a better indicator of investors’ moods.

Second, the Fed is not hawkish – not really. It can however hardly be expected to completely disregard its mandate every time traders want cheap money, so it is natural that from time to time it will seek to reassert its primacy in its co-dependent relationship with financial markets. Having said that, there’s good precedent that when losses mount, it is the Fed that changes its rhetoric rather than markets their expectations. If the economy is still growing and no major risks have unfolded, we should expect such a scenario to play out and eventually lead the market to rebound.

Third, we expect that this is not the final round in the US-China trade negotiations. Downs are usually followed by Ups, and vice versa.

As long as overall growth continues to remain tepid, we don’t expect a blowout in equity index returns. Since global growth peaked at the end of 2017, the S&P 500 returned 3.5% per annum (2% for the UK large caps), a paltry number for stocks expected to return 8% per year. So we are really in a sideways movement, reaching peaks through the strength of psychological exuberance and troughs when that exuberance runs out, with the Fed acting -for lack of a better metaphor- as the occasional purveyor of antidepressant medicine.  

The risk, of course, is that prolonged volatility may help further risks grow into something meaningful. We are thus vigilant, but we wouldn’t expect the Fed to adopt a more dovish language before losses mount, this would mean the S&P hitting roughly the 2600 level (currently at 2840).

This dance we have danced before, and, dare we say, we might dance again.