Is a bear market around the corner? Not yet, but some caution and strategic thinking would help
Varun Ghotgalkar says emerging risks around the world have understandably spooked some investors, though markets do not seem to be heading for a sustained downturn yet
A mix of slowing macro momentum, rising interest rates and growing political uncertainty have raised the possibility that we are heading for a bear market. Although late-cycle warnings are visible, it may still be too early for such a call, given encouraging earnings figures and other positive economic signs.
Regional equity performance was mixed in May with the UK and US outperforming the global benchmark, while Swiss equities, emerging markets and Japan lagged. The euro area, hit by the recent increase in political uncertainty from Italy’s and Spain’s leadership changes, underperformed by 1.1 per cent, which means it has given back gains that the region made earlier this year. Global equity markets are now up 2.6 per cent in the year-to-date with the US back in the top spot.
If we look at the growth by sectors, technology, up 5.7 per cent, appears to be the best performing industry, followed by energy and materials in May. At the other end of the spectrum, telecoms, financials and utilities posted losses in descending order.
The current US bull market has been one of the longest in recent financial history, lasting over 80 months and delivering an annualised real price return of just over 12 per cent in US dollar terms. To put this in perspective, if we look at the history, the 12 S&P500 rallies that have taken place since the 1950s have had a median annualised real price return of 15.4 per cent and have typically lasted around four years.
In 2018, the economic and political backdrop has been more unstable with the Citigroup Economic Surprise Index losing around 50 points, 10-year US Treasury yields moving up by around 50 basis points and the Baker, Bloom & Davis Global Economic Policy Uncertainty Index jumping almost 40 per cent since the end of February. This instability, slowing macro momentum and a faster-than-expected rise in interest rates have resulted in choppy global equity markets since February, leaving investors worried about the prospects of a looming bear market.
However, timing bear markets is a hard task. Every downturn is unique and, because of this, over the long term most indicators are inconsistent and somewhat unreliable predictors. There are macroeconomic and financial market variables which have been fairly decent indicators of bear markets since the 1950s with an average hit ratio of over 65 per cent. Typically, most reinforce each other preceding sustained bear markets – abrupt crashes like Black Monday in 1987, for instance, are the exception.
Currently, while late-cycle warnings are visible, it is still too early for a bear market. Slowing economic momentum from robust levels and ultra-low unemployment are the main alarms. Money supply growth is below the threshold and the ongoing monetary tightening appears well flagged. Similarly, fixed investment growth as a share of gross domestic product continues to expand.
A reversal of this, however, would spell trouble. Although classical valuation metrics like the Shiller price-earnings ratio indicate elevated valuations, this is likely to normalise with the pickup in the earnings cycle. Other indicators, like the equity risk premium and the US Treasury yield curve, still remain in reasonable territory.
Given that the supportive earnings and technical backdrop remain underpinned by robust corporate activity, overall, global equities tend to look positive. Several signs support this view: stock repurchases still appear to be a strong tailwind for the market, contributing to earnings-per-share growth; valuations seem less of a risk; the ongoing monetary policy normalisation appears to be reasonable; and, earnings growth is encouraging.
Nevertheless, with all kinds of risks emerging, notably increased oil prices, fragility in the interest rate space, geopolitical tensions and political sentiment in Europe, investors should maintain a tactical approach while staying cautious for the rest of the year.
Varun Ghotgalkar is an equity strategist at AXA Investment Managers