A healthy correction

In early February, the term “healthy correction” was widely used to describe the significant falls in global markets. But falls of over 4% in a day on some of the world’s biggest stock indices probably didn’t feel healthy for investors. Neither did the possibility that there were automatic computer-generated trades placing large selling orders once prices began to fall, driving stocks down even further.

But stock prices had been breaking through record after record to the point that they were perhaps too high. So an adjustment in stock values seemed healthy because the losses taken now are small relative to what they might have been had prices continued rising before a later correction.

What happened

One person keeping a close eye on stock values is Jerome Powell, the new Chair of the Federal Reserve (“Fed”, equivalent of the Bank of England). He has the unenviable task of making sure the country’s monetary policy continues to help the US economy grow at a sustainable rate while also being mindful of overvalued assets such as stocks and property. If economic growth or rising values gets out of hand, they could provoke too much inflation and a reversal of economic growth.

Figures released in February showed that the prices of goods and services in the US were rising at the target rate set by the Fed, and that wages had gone up by more than expected.

Mr. Powell wasted no time in indicating that he considered there to be an increasing need for four interest rate rises in 2018 alone; there having been only five in total since 2009.

If interest rates increase too quickly, however, borrowing can become too expensive for individuals and companies. This can reduce spending and business investment. This, in turn, could stifle global economic growth and reduce stock prices.

In early February, investor sentiment fell in response to signs that economic growth might be too fast. This led to increased expectations of interest rate rises being instigated by central banks, the knock-on effect of which was investors selling shares sending their prices down.

Political events also added to the market turbulence. The renewal of the grand coalition in Germany provided political stability, but worries over the outcome of the Italian election did little to maintain investor confidence.

Italy needs structural reforms that will help lift economic growth and put the banking system and public finances on a more viable footing. In early March, the Italian election result was inconclusive, leaving the most likely outcome being a broad coalition after a period of inter-party negotiation. While not ideal, this does reduce the likelihood of Italy withdrawing from the euro currency as had been mooted by the 5-Star Movement, which won more than 30% of the vote.

Unpleasant medicine

It should be borne in mind that the initial declines in stock values took prices back to roughly where they started the year, levels reached after sustained record-breaking gains.

The falls probably have helped to take some of the excessive valuations out of the market, hence the “healthy” reference.

Turning to fixed income investments, we have seen a fall in bond prices and corresponding rise in yields this year (the price and yield of a bond always move in opposite directions). This has been driven by rising interest rates, stronger economic growth, rising inflation and the reduction or reversal of bond-buying by central banks. As US government bond yields headed up towards 3%, such returns began to look increasingly attractive as an alternative to higher-risk rated assets such as equities. So bond prices fell to a level at which they were considered by some to be attractive again. This competitive dynamic between stocks and bonds looks likely to continue which could contribute to price movements.

Economies ≠ stock markets

These events remind us that strong economies do not necessarily mean strong stock values.

The global economy continues to grow and the outlook is much rosier than many expected a couple of years ago.

Also, investors ought to be reassured by the strength of company profits, and by the higher dividends that these allow.

Corporate profits in the US have been particularly strong, and expectations for tax cuts have boosted estimates for the near future. Inflation is expected to edge higher, but probably won’t surge dramatically.

Implications for investors

The sell off is also a reminder of the need to understand how the share price of a company relates to the underlying value of the company: A fair share price is likely to reflect the quality of the underlying company and its ability to generate profits and dividends or growth over time.

Finally, recent events also serve to demonstrate why we focus on the longer term investment horizon and diversify our portfolios so as to help mitigate shorter term volatility such as we are seeing at the moment.

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Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at March 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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