It ended on a high note last week, but overall October was a rotten month for equities. The world equity market has just had its worst month since 2012, with the benchmark MSCI world index down 7% in October. This fall has more than reversed earlier gains, leaving the global index down 3% so far this year.
October saw significant declines in most major equity markets, with falls of 9% in Japan and the euro area, 7% in the US and 5% in the UK and emerging markets.
The equity sell off and last week’s bounce reflect two conflicting readings of the global outlook.
The bears, or pessimists, think that rising US bond yields and slowing global growth mean the best is over for equities. Interest rate rises in the US, and an unwinding of quantitative easing, have pushed up yields, or interest rates, on US government bonds to a seven-year high. Higher yields affect equities in three ways. Improved returns on bonds makes equities less attractive by comparison. Higher yields also depress the current value of future dividend income. And in the long term higher rates and tighter monetary policy spell weaker growth and lower profits.
Bears concede these factors matter less when global growth is accelerating. But in emerging markets and the euro area the momentum of growth is slowing. US growth looks close to a peak. The risks to global growth are looming larger. The mood change was captured in last month’s Economist cover story, “The next recession, how bad will it be?”
Concerns over the effect of tighter US monetary policy and protectionism on the global economy, especially emerging markets, have raised fears about a harder landing for the global economy. Last month the International Monetary Fund cut its forecasts for growth in advanced and emerging economies.
The latest Fund Manager Survey by Bank of America Merrill Lynch reports that institutional fund managers are now more pessimistic about global growth than at any time since the depths of the financial crisis in November 2008. The survey also found that a record 85% of respondents think the global economy is in the late stage of the business cycle.
In a recent Financial Times article the economics commentator, Chris Dillow, analysed the history of equity markets’ ups and downs. His analysis of stock market data showed that good five-year periods in US and UK markets tend to be followed by bad periods – in much the same way that economic booms are followed by busts. If he’s right a 60% rise in the US S&P500 index in the last five years could presage a bumpier ride for investors.
The equity bulls draw exactly the opposite conclusion.
In the year to the third quarter profits for firms in the S&P500 rose a hefty 26%, the fastest rate in eight years. Despite stellar profits growth US equities fell in October, something which the bulls attribute to excessive gloom about the economic outlook. They observe that while growth in Europe and emerging markets has softened, the risk of a recession remains low and the US economy is going from strength to strength. The US market has seen bigger setbacks, in late 2015 and earlier this year on similarly excessive worries. These setbacks proved to be buying opportunities. And then there’s the fact that US wages are, at last, rising. That could prompt companies to go on an investment binge, lending a new impetus to productivity and to profits.
Bulls tend to see the recent action in the US equity market as reflecting a shift in investors’ preferences, not a flight from equities. On this interpretation investors are moving from fast-growing, but pricey, tech stocks paying low dividends to cheaper ‘value’ stocks that pay higher dividends and will gain from strong growth. So, for instance, Netflix, whose share price soared until September fell 17% last month while Proctor and Gamble, whose shares had drifted lower through the year, rose 7%.
For the bears the best is over. The bulls think that the recovery has more life left in it and that investors have become too pessimistic. As in all such debates only time will tell who is right.