This week in the markets: Reset
Any hopes that last week’s two-day rout in global stock markets would be the full extent of market turbulence were confounded on Monday morning when first Asian and then European markets continued to plunge. Thursday and Friday were among the worst two-day performances in 40 years, only matched by market moves during the dot.com crash in 2000 and the financial crisis in 2008. But the selling continued after the weekend.
The post-election Trump Trade was killed off by last Wednesday’s Rose Garden tariff announcements and the subsequent responses around the world, notably China implementation of retaliatory and matching tariffs on imports from the US. Investors are rapidly re-calibrating their expectations from optimism about growth and deregulation - the so-called Trump Trade - to a bleaker reality of tariffs, trade war, inflation and an increasingly probable recession.
The scale of the falls either side of the weekend evoke memories of the 1987 crash. What we are witnessing is a complete change of the market narrative and an immediate repricing of risk. When markets such as Hong Kong fall by as much as 13% including a 15% fall for HSBC shares, Germany’s Dax is down by 10% at the open and the FTSE 100 adds another 5% fall to the already substantial plunges last week, it is a dangerous time to get in the way of the juggernaut.
As one Tokyo-based investor neatly summarised the situation this morning, it is almost impossible to sensibly respond to what is happening in the markets. Inaction may be the most prudent approach. If tariffs stick at their current levels, it is not too late to sell shares, the investor said. But if they are unwound, there will be the mother of all rebounds. It is impossible to judge which outcome is more likely, so doing nothing is probably the least risky path.
At the time of writing, futures markets were pricing in a third consecutive day of heavy falls for the US market. If this is what transpires, this will be one of the worst weeks in the market since Black Monday in 1987. It is worth remembering that stock markets ended that year higher than they started it. Keeping a calm head at times like these is difficult, but necessary.
The heavy falls in markets come as Goldman Sachs raised its estimate of the probability of a US recession to almost 50%. That matters because history shows that market corrections are much more likely to turn into full-blooded bear markets - a sustained fall of more than 20% - in the context of a recession. It means that once this initial reset phase has run its course, investors will need to start to think in a calm way about how to position their portfolios for a tougher economic landscape ahead.
At the very least it shortens the odds on the Trump tariff shock being the catalyst for the end of both the 30-month cyclical bull market since October 2022 but also the 16 year secular bull market since the financial crisis in 2008. The technique of buying the dips - taking advantage of temporary falls in prices - may not work so well in the immediate future.
Perhaps unsurprisingly, the Trump administration is so far showing no inclination to back down on the tariffs that have triggered the turmoil. ‘Sometimes you have to take medicine to fix something’ was the President’s assessment to reporters over the weekend. He was speaking after more than $5trn was wiped from the value of the S&P 500 on Thursday and Friday in the worst week for shares since the worst of the Covid pandemic in March 2020.
Investors with balanced portfolios have been spared the worst of the equity market plunge. Safe haven bonds, such as US Treasuries, have risen sharply in price as their yields have fallen. Yields and prices move in opposite directions. The yield on the 10-year US government bond has fallen below 3.9%, which compares with a recent high of around 5%.
But there have been few other places to hide. Commodities have fallen sharply too. Brent crude has fallen to $63 a barrel, it’s lowest level in four years. Copper, which is often seen as a bellwether of global economic growth fell more than 7% on Monday to $8,690 a tonne. Bitcoin, seen by some as a safe haven, but in reality a volatile risk asset, has fallen from a recent high above $100,000 a coin to under $80,000.
Gold, a traditional safe have in difficult times, has also fallen from recent all-time highs as some more leveraged investors have been forced to sell what they can rather than what they might choose to. The dollar, often viewed as a port in any global storm, has also weakened as investors have started to question the US’s economic leadership in a post-globalised, more protectionist world of isolated trading blocs.
One key measure of market volatility, the Vix index that is sometimes known as Wall Street’s ‘fear gauge’ rose above 60, its highest reading since the market turmoil of last August. A level above 30 is seen as being associated with extreme volatility and has been rare in recent years. The long-term average is around 20.
Looking beneath the surface of the major national stock market indices, the hardest hit shares have been some of those that rose most recently. In Europe that includes Rheinmetall, an industrial group seen to be a major beneficiary of the region’s re-armament push. It fell 16% on Monday. Bank stocks were big fallers in Europe too. Germany’s Commerzbank lost 10% and Spain’s BBVA was 8% lower.
In Asia, China’s sovereign wealth fund said it had increased holdings of exchange traded funds tracking the main Chinese indices in a bid to put a floor under Monday’s falls. Circuit breakers - a temporary suspension of normal trading - were triggered in Taiwan and South Korea.
Asia is seen as being one of the areas that will be hardest hit by Donald Trump’s protectionist moves as it has been the biggest beneficiary of globalisation in recent decades. Most Asian markets are now in negative territory for the year as a whole. Japan’s Topix index is down 17% year to date. Only Hong Kong’s Hang Seng index is holding on to a modest gain for the year, but only a few weeks ago it was up by 23%.
At times like these, it is worth remembering some important investment principles. First, while markets rise over time, they do not do so in a straight line. The price we pay for the long-run outperformance of equities compared with apparently safer assets like bonds and cash is the volatility of the stock market. But the longer-term returns only accrue to investors who are able to hold their nerve during moments of market dislocation, who avoid crystallising losses by selling after sharp falls, and even take advantage of market falls to top up their holdings at attractive prices.
The reason why staying calm matters so much to investors is that the best days in the market very often follow hot on the heels of the worst days. Investors who move out of shares into perceived safe havens can easily find they miss out on the subsequent market recoveries. And that can have a significant negative impact on their long-term returns.
In the long run, stock markets are driven by the earnings of companies listed on stock markets and the multiple of those earnings that investors are prepared to pay to own them. Earnings come into the spotlight this week as the first quarter results season kicks off. There is always a lag before a slowing economy starts to show up in lower earnings figures but already expectations are starting to moderate from the low-double-digits profits growth that analysts had pencilled in.
As for valuation multiples, they respond immediately as markets fall. From quite stretched levels, particularly in the US, valuations are quickly falling back towards long term averages even if they do not yet look cheap. The price-earnings multiple of the S&P 500 index has already fallen from nearly 26 to around 21 on the basis of historic or announced earnings. The same ratio for the equal weighted version of the US benchmark is down to 16 at which point it is much closer to what might be considered fair long-term value. So much depends on how earnings will hold up in the weeks ahead.
One final consideration is how the world’s central banks will respond to the market turmoil. The likes of the Federal Reserve and the Bank of England find themselves in a difficult place. The dilemma created by last week’s tariffs is that they are likely to lead at the same time to both higher inflation and lower growth. That is a vicious cocktail for a central bank which is tasked with both supporting growth and capping inflation.
It is hard to do both at the same time with the blunt instrument of interest rates. Cutting rates might seem like the obvious thing to do to promote growth, and the President has already called on the Fed to do just that. But fresh from the post-pandemic spike in prices, and mindful of what happened in the 1970s when inflation was let out of the bag by a complacent central bank, the Fed will be wary of moving too fast.
