“Sell in May and go away,” used to be the saying in the UK stock market many decades ago. Admittedly, that was reinforced by the expectation that little of note would happen over the summer months. How times have changed, as now 24/7 global news means it is rarely possible to switch off.
In recent weeks financial markets across the world have been impacted by a combination of inter-related factors: concerns that the world economy may be losing momentum; worries about the fallout from policy in the US, as the Fed looks set to tighten further and President Trump’s threats of a trade war are followed by the first steps in actions; and the reappearance of concerns that financial markets are overvalued and may be due a correction.
In terms of the latter it is largely concerns about stock markets, whereas at various times in recent years there have often been worries that bond markets are overvalued. Now, continued low inflation and concerns about growth have given bond markets some support. To all of this, here in the UK, can be added the latest gyrations in the Brexit debate. These look set to continue.
A global slowdown? But too soon for pessimism
The first message is that the world economy does appear to be slowing, but gradually. Also, pulling the various strands of conflicting economic news together, the US economy is in a stronger position than most other major economies, justifying both the upbeat message from the US Federal Reserve and the increase in US interest rates. Meanwhile, elsewhere, the growth picture is mixed and thus central bankers are hedging their bets in terms of policy actions.
The world economy lost momentum in the first quarter, with bad weather playing its part in Europe, and monetary indicators, which we have alluded to before, suggesting global growth may slow further. The underlying issue has been whether growth could be resilient in the face of monetary tightening and central banks would be able to fine tune their exit strategies in a way in which both economies and markets could cope.
The strength of labour markets in western economies does, however, suggest that while things may be slowing slightly, it is too early to become pessimistic about worldwide growth. There is still much economic resilience. Job growth remains firm. In the past, labour markets were seen as lagging indicators – because of firms’ hiring plans they were seen as better reflecting what had happened.
But where labour markets are flexible – such as in the UK and US – it is fair to say they are now more of a coincident indicator, often providing an up-to-date insight into how the economy is doing. So in that context solid jobs growth in the US feeds expectations that the Fed will hike further.
As ever, risks should be assessed carefully
The second message is that the escalation in trade tensions needs to be taken seriously. Global trade imbalances are a valid concern but once countries embark on a policy of higher tariffs the immediate net effect will probably be negative. But we need to see how the politics unfold.
Third, when it comes to the outlook for financial markets the issues are whether they are discounting too much good news about the economy, and in particular, a continuation of non-inflationary growth. Are markets taking enough account of the risks and pricing for them appropriately? On the former it would seem to be that either growth slows or central banks tighten policy. That creates potential tensions although it does not mean markets will crash. Rather, it means risks need to be assessed carefully, which should always be the case.
Recent risk insights: good news and bad news
Regarding risks, in the wake of how markets were impacted in 2008 we naturally keep a close eye on financial stability issues. And in that context, recent weeks have seen the release of two key documents that provide insight into where the big risks are seen as lying: the annual report from the Basel-based Bank for International Settlements (regarded as the central bankers’ bank); and the Bank of England’s half yearly Financial Stability Review.
The good news is that the major worries are still the same ones as identified before, although the bad news is that there are lots of them.
The Bank of England report noted an increase in global vulnerabilities, citing trade tensions, China debt levels, the rise in Italian bond yields and the impact of higher US rates on emerging markets. These are all valid concerns and, if anything, highlight the challenging aftermath of a low interest rate policy across the globe. The BIS report was very focused on these global risks, including the high valuation of markets.
Also, the Bank of England report noted the recent changes in the UK’s private debt picture. Given the overall policy focus in the UK on reducing the government’s budget deficit, all too often not enough attention is focused on the private debt situation. It needs to be. If private debt gets out of hand it can be a sign of economic problems to come and could give the Bank the opportunity to assess the economy’s ability to cope with higher rates before they tighten.
Annual credit growth of 4.7% in the year to 2017 Q4 is not exceptional and is broadly in line with the economy’s increase in growth and the rise in inflation. The level of household and corporate debt is materially below its 2008 peak when it was 144% of GDP. However, latest data shows a figure of 125% at the end of 2017, which is still at a relatively high level given the performance of the economy and could become a problem if economic conditions deteriorated or, in contrast, interest rates rose too far. Currently, the cost of debt servicing remains low, but remains a key indicator to monitor as the Bank of England threatens to hike rates.
Interestingly, the Bank reports that 1.3% of households have mortgage debt service payments above 40% of disposable income – this is the threshold above which there may be repayment difficulties. Moreover, interest rates would have to rise 1% for the ratio of mortgage payments to disposable income to return to their 1997-2006 average. Perhaps all of this explains the need to focus on wage growth and the ability of people to cope with higher rates.
Overall, as we move into the summer there are many issues to consider when managing investment portfolios. It is no longer appropriate to sell in May and go away, but far better to not lose sight of the risks, while keeping focused on the longer term.