Sunday, 22 July 2018

On expectations and corrections

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Anthony Peters on pulling asset balloons back down to earth.

If anyone came in yesterday thinking it might be an ugly session, confirmation is now there … in spades. US equity markets lost between 2% and 2½% across the major indices with only the trusty Dow Jones Utilities Index holding up by shedding “only” 0.91% and with the S&P 400 MidCap taking it fully on the nose by losing 3.62%.

The equity sell-off, apparently accelerated by an unexpected decline in the US purchasing managers’ index for manufacturing – although still north of 50 and hence in expansionary mode – has carried through into Asia and seemingly become more ugly along the way.

Japan once again has borne the brunt with an already bettered Nikkei losing a further 4.28% in value and the TOPIX dropping 4.77%, the former now being down 14% since the beginning of the year in local currency terms and 10.35% if hedged into dollars.

End of the world or healthy correction?

For the while I see nothing to worry about. Even after the current sharp declines the Nikkei 225 is still up 24.4% since this time last year which is not to be sneezed at and the S&P 500, by the same measure, is 16½% higher. I cannot repeat often enough that markets aren’t the economy and the economy ain’t the markets. If expectations of what the US economy was going to achieve were ahead of reality, then that is the mistake of the expecting investors, not necessarily of the economy which is, by all measures, still doing very nicely, thank you. There is currently no need to predict and price the next recession.

I am still not prepared to buy the story that what we are seeing in markets is the result of Fed tapering. 

That said, there has always been this tacit acceptance that a single economic cycle lasts around seven years. The Greenspan induced postponement of the cyclical downturn of 2001/2002 – we’re talking post 9/11 here – knocked that particular cycle of kilter but it did not, per se, banish it. It could therefore quite sensibly be argued that the steep post-crisis recovery is due to fade and that a period of consolidation is upon us.

The longish and sharpish downturn brought with it a back-log of demand for capital goods and consumer durables and markets might easily have made the mistake of looking for a linear of even accelerated increase in the growth trajectory of the past three years or so rather than having anticipated a flattening and/or normalisation of growth.

No Panic

If markets overestimated the ability of the economy to produce and to consume – remember that the last big consumption driven economic boom was largely driven by paying for imported goods with borrowed money – then a re-evaluation and consolidation is neither wrong nor overdue. Nillus panicus.

I am still not prepared to buy the story that what we are seeing in markets is the result of Fed tapering. More to the point, chatter around the Street that the initial rout in emerging market currencies and subsequent price decline in all manner of asset classes might motivate the FOMC to review the speed of tapering has me worried. The Fed is here to help maintain the stability of the economy and not the price of financial assets. That the S&P clocked over 26% of gains last year is the markets’ matter and not that of the Federal Reserve and hence, if it declines again, so that is not the Fed’s matter either. It owes the Wolves of Wall Street nothing at all, no matter how important they think they are and even if they do believe that they are doing God’s work. Godot’s maybe, but not God’s.

But what is the humble investor to make of all this? Buy it or sell it? I’m not entirely unhappy with the pull-back in equities and am not at all in the mood to hit the panic button. I still chuckle when I think of Jim Saft’s recent observation that investors tend to have mistaken riding a wave for being able to swim fast. Equity holders got a lot for nothing last year and although it would have been nice to have locked in some profits ahead of this correction, they might think of what is going on as handing back what wasn’t really theirs to start with. Likewise, bond longs are now enjoying what is effectively a bit of undeserved performance.

Unless one is seriously convinced that we are the beginning of a new cyclical down-turn, there is no reason to reshape one’s investment strategy. I am not; we’re just blowing the top off a bit of too far, too fast.

Elsewhere, the spectre of a bust in the London property bubble is looming again. It has been looming since I first moved here in the 1980s and whoever positioned for the big correction by selling and renting in order to buy back in lower down has had a pretty grim time. It is understandable that a decline in China’s growth story with the concomitant commodity wealth in countries few can find on the map is expected to dampen demand.

Likewise, the increase in US hydrocarbon output is forecast to seriously damage the wealth of the Middle East. However, there remains enough political uncertainty to continue to drive the rich to the city and when one set of price-insensitive buyers fades, another one emerges. It is said that economists are the people who forecast five out of the last two recessions. Property pundits have done the same for ten out of the last two house price corrections in London town.

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