Equity markets are in the eye of the storm again, and it is not only emerging ones that are getting hit. In a move reminiscent of the decline in February the trigger point seems to be the sharp rise in US Treasury yields, causing volatility across all asset classes.
This time, however, there is an additional overhang of an extended trade confrontation between the US and China. The length of the confrontation and lack of progress in resolving it is deepening investors’ anxiety as they worry about the fallout on corporate earnings.
If both of these issues persist then corporates will feel the pinch on both revenues as well as the cost side at a time when the benefits of tax cuts are beginning to fade.
There is also the intangible ‘Trump factor’ which is finding its way into the market through higher oil prices, geopolitical risks and at times inconsistent policies. The loss of US leadership in maintaining the post-war consensus over the benefits of free trade is also part of the problem. The IMF downgraded its global growth outlook last week, by 0.2 per cent, but it also warned that a trade war could knock a further 0.8 per cent of its baseline forecast by the end of 2019.
If rising US interest rates were not enough of a problem President Trump’s criticism of them adds another complication. Last week Mr Trump said the Federal Reserve was moving too fast with rate hikes, describing Fed policy under Jerome Powell as ‘going loco’, reiterating his longstanding criticism of the Fed. This may be a turning point, however, as it appears to be an attempt to more actively undermine Fed independence. This could cause investors to lose confidence in US economic policy at home, at a time when ‘America first’ policies abroad are threatening to undermine the international monetary system and potentially accelerate a process of ‘de-dollarisation’.
Unlike previous sell-offs, this time the US markets are also participating in what appears to be a process of catching up with declines in emerging markets and a general risk aversion in markets outside of the US. This contamination of major markets is something frequently warned about and now appears to be happening. However, despite the decline of 4.7 per cent over the past week, the S& P 500 index is still up 3.5 per cent for the year compared to a decline of 15.5 per cent in the MSCI EM index and 7.7 per cent in the MSCI Europe index. More pronounced weakness in the broader based Russell 2000 index perhaps also portends that a much deeper correction in the S&P500 could be on its way.
Running into the final months of the year, there are few signs that any of the issues behind the latest market sell-off are likely to disappear. If anything the coming months present more risks than opportunities. By actually increasing the running down of its balance sheet this month, the Fed is signalling that it intends to follow through on its pledge to raise interest rates once more this year, probably in December, and three more times in 2019.
As the US mid-term elections on November 6 draw nearer this may provoke more fury from Mr Trump about interest rates, with his rhetoric over trade and China unlikely to diminish much either. What the mid-terms then deliver in terms of results could also add to Mr Trump’s tendency to lash out at perceived enemies at home and abroad.
Elsewhere the European Central Bank also cut its pace of asset purchases last month and is promising to end them completely by the end of this year. This at a time when Eurozone growth is slowing down and the Italian budget stand-off threatens a repeat of earlier Eurozone debt and banking crises. Of course Brexit talks are another source of risk, while China’s handling of its own deleveraging remains problematic in the context of slowing growth too.
In some sense, it is no surprise to see volatility in the US finally catching up at a time when normalisation of monetary policy around the world is finally picking up pace, and investors will probably have to learn to live with it.
Tim Fox is the chief economist and head of research at Emirates NBD