Short and Sharp: Peering through the volatility

Market volatility since the start of December has been stunning. Already fragile sentiment was undermined by negative news flow, and equity and credit markets both signal a depressing outlook for the global economy. But with price moves exaggerated by the typical year-end drop in liquidity, I’m reluctant to believe anything fundamental has changed.

In fairness, the December US ISM manufacturing survey was a disappointment, as were several confidence surveys. But then again, December’s employment report showed larger-than-expected jobs gains and a solid rise in average hourly earnings. While economic growth is clearly slowing, the strength of the labor market should pause the recession chatter.

Trade discussions have advanced with this week’s US/China trade talks reportedly ending in progress. Back in July, when I first started discussing how the trade war would eventually weigh on US equity markets, the focus was on business uncertainty, supply chain disruptions, and increases in import prices. If the latest talks result in a deal that prevents a new round of tariffs, this would resolve many of those concerns and reduce global growth fears.

But in recent months the trade war has shifted from focus on China’s current account to China’s quest for tech domination – something that is unlikely to be resolved in the near term. Further US pressure via export controls is likely with negative repercussions for the tech sector – and US equities overall.

A real concern is that, should financial conditions deteriorate further, this would weigh on confidence, posing a downside risk to growth and creating a vicious negative cycle. Indeed, the overwhelmingly negative market response to the Fed’s comments at the December meeting is clearly the reason why Chairman Powell felt pressure to provide a more reassuring message last week. He emphasized that monetary policy is not on a “preset path,” and that the soft inflation readings allow the Fed to be “patient.”

A March hike looks to be off the table and future decisions will depend on data. If growth in the US disappoints beyond the slowdown that was already projected, a longer pause can be expected, whereas if growth positively surprises then further hikes will be back on the agenda. But is this really a win/win situation for markets then?

Either way, the resoundingly positive reaction suggests that Powell may have stemmed the market rout for now. There are also other reasons to believe a Q1 equity market rally is possible. For a start, the equities have recently had far too much conviction about the chances of a recession. This, in itself, argues for an upward correction. Capitulation across the market means that equities are no longer heavily over-owned (a strong technical), while valuations are also notably more attractive.

But the longer-term reality is that, without the fiscal stimulus and easy financial conditions of 2018, markets must adjust to a weaker 2019 economic outlook, continued pressure on the technology sector, and slowing earnings momentum. An economic recession may not be in the cards, but an earnings recession may continue to wreak havoc, causing equity markets to repeatedly test the lows of last month.

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