Market volatility is continuing with little sign of long-lasting relief.
Recoveries have been sold and a “sell the rally” mindset has replaced the “buy the dip” attitude. This has led many analysts to wonder whether there is fundamental support for the market correction.
Reading through many reports, some with apocalyptic headlines, we note an effort to retrofit macro reasons to the market swoon. China and oil have given way to other excuses. The most frequent rationale is that a US recession must be coming.
We disagree with this. The cycle may have been long, but in seven years it has only achieved the closing of the output gap that took two years in other cycles. The traditional excesses before recessions (overleverage, capex boom, spending spree) are notably absent. Only widening high yield spreads and soaring M&A volumes are standard forerunners of a recession. The large pickup in high-yield spreads is driven by energy, and the contagion to other sector spreads is triggered by mechanical, rather than fundamental, factors.
If market volatility continues for a long time, there is a risk of contagion to the real economy, as individuals and corporates alike change their investment and consumption behaviour. So why are markets so bent on a self-fulfilling recession prophecy?
Many investors are tired of central banks throwing endless liquidity at an economy that will not stand on its own two feet. NIRP (negative interest rate policy) is the new quantitative easing (QE) and is now the favourite tool used by the European Central Bank, Bank of Japan, Sweden, Switzerland and Denmark.
NIRP is used to try to encourage banks to put more of their excess reserves in the real economy, but markets are sceptical that it will achieve the growth boost that eluded QE. The perception that central banks are losing credibility has been one of the main elements weighing on markets recently, and there is a risk that NIRP is regarded as a reactive measure rather than a valid economic tool.
This analysis, though, is based on two disappointing quarters for the US economy with no other country in the world making up the difference. Extrapolating them could be dangerous, though.
One interesting piece of data is that 2015 was the strongest year in the cycle for consumer spending, at 3.1 per cent growth. Consumer income in the US has far exceeded expenditures during 2015. There is significant pent-up consumer demand that could boost top-line growth for companies. Euro-zone consumers have spent their oil dividend, but US consumers have not.
Why? Maybe because like in 1986 and 1998 when oil prices also collapsed, they need a longer period of stable fuel prices to feel comfortable about spending the windfall.
Right now, expected earnings for 2016 are barely above last year’s figures. This is unusually conservative, as estimates tend to start in the mid-double-digit area and be downgraded throughout the year.
In addition, European banks are under pressure from markets with concerns about their capital and earnings. We should draw a distinction, though, between earnings growth, which may be challenged owing to muted lending, negative ECB deposit rates and non-performing loans in some countries, and solvency, which should be beyond doubt, given the much safer capital ratios than in the past.
Market corrections take on a life of their own. This one will need better and stable market cues to rectify its direction. Economic data, particularly in the US and China, need to improve and corporate earnings need to beat forecasts. First-quarter 2016 earnings will be a bellwether for any changes in market mood. The recent fall in the US dollar, especially against developed currencies, does not seem to have made a difference in commodity prices or in US earnings expectations.
Markets will need quite a bit of convincing to change their minds, but when it happens, the swing could be massive.
Michel Perera is the chief investment strategist for Emea at JP Morgan Private Bank