The beginning of 2018 started with many market participants and pundits very confident and optimistic about the prospects for 2018. It is clear that the year has not gone the way the consensus was hoping.
There are now two schools of thought. The one would argue that just as some bears were capitulating, their views may in fact be coming to fruition now. The other would have you believe that the present cycle is not yet peaking. They argue that some classic late-cycle indicators remain somewhat elusive, such as strongly rising inflation, falling profits, over-investment or aggressive policy tightening.
Which school is correct? To my mind, it would appear that a number of developments have been pointing to increasing potential for a more difficult market environment coupled with some late-cycle markers. To list just some of the factors: The bear market in bonds; softer property prices in major centres around the world; the sell-off in emerging markets; reports of plans to build even taller skyscrapers in certain parts of the world - a classic reflection of upbeat sentiment and a late-cycle phenomenon; speculative and contagious activity in cryptocurrency markets such as Bitcoin; geo-political developments such as North Korea, Brexit and potentially “Italexit”; ascendency and proliferation of separatist and far-right movements and authoritarianism; trade wars that could spin into currency wars; tighter monetary policies (“quantitative tightening”; shrinking US dollar liquidity on the back of these developments; a passive investing trend triggered by late-stage market rallies; narrowing market breadth with a declining number of stocks leading the market upwards; and an extreme bullish sentiment and related gauges.
Against the above backdrop, of concern has been rising US interest and bond rates, government borrowing and the repatriation of US corporate profits, sucking US dollar liquidity out of global financial markets. In a recent note, Nedbank CIB strategists concluded that “as the global economy and financial system have become more systemically leveraged, their sensitivity to changes in the cost of global capital has increased; hence, we believe the next downturn may be more serious than previous ones”.
I think there has been a tendency to forget the lessons of the previous crises as bullish market conditions continued. Furthermore, with pundits assuming that major central banks will continue to forestall or backstop any negative developments, the appetite for risk tends to escalate.
In conclusion, the latest sell-off in global markets is precariously poised.
Either the optimists will win the day if the market recovers and resumes its now shaken bullish momentum, or market participants will increasingly give vent to an underlying uneasiness and a growing negative mood by taking risk off the table.
The risks are high and further strong market sell-offs could well damage the bull market that has been in force since the GFC of 2008.
Fabian de Beer is a director: investments at Mergence Investment Managers.