The decade since the global financial crisis has been called the most hated bull market in history. Even as stock markets have continued to rise, there have been constant concerns about any number of risks that could derail their growth.
The past six months have presented a perfect example of these tensions playing out. When markets fell in the final quarter of last year, they fell rapidly. Their recovery at the start of 2019 has, however, been just as quick.
This illustrates the kind of uncertainty that many investors still see. There are competing forces at play, making it very difficult to know what is going to happen next.
Speaking at the Morningstar Investment Conference in London, Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management, said there are three factors investors should be aware of over the course of 2019 – what central banks are doing, Chinese growth and company earnings.
“I would say that the biggest contributor to volatility in the last six months has been the [US] Federal Reserve,” said Ward. “We’ve seen a complete about-turn in what the Federal Reserve is telling us about their policy.”
In September, the Fed was still talking about being restrictive as the US economy was growing strongly and wage growth was picking up. By February, however, its language had changed. Not only was it no longer looking to raise rates, it was also talking about ending its balance sheet contraction this year.
“That’s what the market loves,” said Ward. “We are QE [quantitative easing] junkies. We love what the extra liquidity does to the system. That is what has really led markets to roar this year.”
More dovish tones from the European Central Bank and the Bank of Japan have also sent long-term interest rates lower around the world. This has encouraged stock markets, but does highlight another risk.
“The main risk I worry about at night is corporate debt,” Ward said. “Whenever we think about expansions and recession risks, I am always looking for where the excess is in the system. In my view this time around it’s the massive expansion we’ve seen in corporate debt, using both public and private markets, the deterioration in quality we have seen in credit markets, and the problems that can cause.”
The chart below shows how the share of BBB-rated bonds in investment-grade indices has been rising in major markets, and is now above 50%. BBB is the lowest investment-grade rating.
While Ward does worry about this, other signs that she usually looks for signalling a recession are not giving immediate warning signals.
She does not therefore see a recession coming this year, although the US economy is expected to slow. What will cushion the effect this might have on markets, however, is that she expects Chinese growth to improve.
“We have to stop obsessing about everything that is the US, because actually China is now the main impulse through the global economy,” said Ward. “You only have to look at last year to see that. The US was booming, and yet the rest of the world had a pretty awful year. That’s due to China.”
As the chart below shows, China and emerging markets have been comfortably the largest contributors to real global GDP growth this century.
Last year the Chinese authorities were looking to slow the economy because they were growing concerned about the property market, and the levels of leverage and debt.
“But it turns out they slammed a little bit too hard on the brake,” said Ward. “The good news is that they realised they were a bit heavy handed. They are off the brake now and back on the accelerator.”
This, again, is supportive for equity markets. However, Ward still sees a significant reason for investors to be cautious.
“The bounce in stock prices this year has been due to multiples expanding, not because analysts are getting more excited about the outlook for earnings,” Ward pointed out. “Multiples can only take us so far. We need earnings to be revised up, and that’s where I get a bit nervous.”
This is because wages in the US have started to go up, as the chart below indicates. The risk is that this will eat into corporate margins.
This leaves investors in a conflicted place.
“We are late in the cycle, and even though I don’t think we’re going to get a recession, those higher wages are going to eat into corporate earnings,” Ward said. “At the same time I have the Federal Reserve pushing me to search for yield, telling me I have to stay in risk assets because where else am I going to go?”
She believes the best approach is therefore to stay invested, but be careful about managing risk.
“Focus on larger caps rather than small caps, value rather than growth, and screen for quality,” Ward advised. “When things go wrong it’s going to be due to corporate leverage. You don’t want stocks that are highly indebted and struggling to refinance.”