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Difficult week tees up bigger stock market correction

arkets participants found themselves in the rare position of witnessing falling prices this week. It has naturally sparked questions of whether a larger correction is in store. The Dow Jones has pulled back 3% while the FTSE 100 has dropped nearly 4.5%. These are relatively small moves and based on recent experience, the mostly likely scenario is dip-buyers step in to send markets back up again. However, maybe this time will be different. The market has reached some new extremes in sentiment during January and certain risk-factors, notably the rise in bond yields, could point to further stock market declines. It’s conceivable that the Bitcoin bubble bursting has meant retail equity investors were meeting less margin calls.

 

Bond market woes spread across markets

Rising bond yields have put stock markets on high alert. 2.6% was the first ‘worry level’ in 10-year US treasuries. A 3% 10-year treasury yield is the big kahuna for a larger stock market correction. After many stops and starts in US interest rate rises, investors increasingly seem to be feeling like this tightening cycle could be here to stay. The phenomenon is global though. The UK gilt yield has hit its highest since May 2016. India’s 10-year bond yield hit a fresh 22-month high. Rising interest rates mean the ‘goldilocks’ scenario for markets is warming up to ‘daddy bear’.

 

Fading the Davos global growth rebound

Lord Jim O’Neil amusingly said the best thing about the World Economic Forum in Davos is that it is one of the best reverse indicators. In his words “The consensus, trendy, idiotic tone of Davos is usually a thing to fade.” One of the main themes of Davos was optimism about global growth. Add to this, the IMF raising its global growth forecast and you have two strong contrarian indicators. This theory is backed up by a downturn in Citigroup’s global economic surprise index. Stronger growth has brought about unrealistically high market expectations, which are now being disappointed. Stocks were lagging the economic disappointments and now they are catching up.

 

Tax cuts & earnings already priced into the US

All the big impetuses for the move higher in US equites are either priced in or reversing. The near vertical move higher in US stocks over the past 3 months were markets pricing in the value of Republican tax cuts and solid full-year earnings growth. These would now appear to be fully priced in. What probably isn’t fully priced into bond markets is the inflation and higher deficits that will likely result from the tax cuts.

 

Central bank balance sheets

Central bank stimulus, which has spurred demand for risky assets for the best part of a decade, is gradually being removed. The Fed may have been raising rates for two years but it has only just started reducing its balance sheet. Then, only by mid-2018 will the combined balance sheet of the Fed, the ECB and the BOJ start decreasing. Central banks have been signalling tighter policy for a while but markets are only just starting to come to terms with it actually happening.

 

UK stocks take a pounding

UK share prices have had the triple whammy of a rising rates, a strong pound and disturbingly negative reactions to some earnings. The enduring strength of the pound despite a bitter political climate has been difficult for the FTSE indices. The failure of the FTSE 100 to hold its breakout above 7,600 spells out further weakness to come. The FTSE 250 looks headed for a re-test of the 20,000 level. Looking out to the continent, things haven’t been much better this week. Germany’s DAX has turned negative for the year and whether it holds support near 12,800 could determine if the worst is over or not.

 

Is a bigger correction coming?

There’s a good probability, given the extremes in sentiment and concern that the bond market has shifted into a new paradigm, that stock markets experience a 10% pullback sometime in the first quarter. This of course needs to overcome the strong upwards momentum still present in markets.

 

 

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