Given the extent of the recent falls in equity prices, what direction could stock markets take next?
What a turbulent start to the year. Concerns over growth prospects in China, oil prices plummeting as if there is no bottom, and lingering fears that the US Fed may have tightened policy too early have all clouded the outlook for global growth and sent stock markets in a tailspin so far this year, led once again by the Chinese market (see chart below).
Looking at the fundamentals, one measure of stock markets valuation - the cyclically adjusted price-earnings ratio (CAPE) – is relatively positive. US CAPE fell from 26 in December to 24 by 13th January (see chart below). It was still above its historic average, but some European markets were more attractive on this measure. Equity markets in the UK and Germany had lower CAPE by the end of 2015, around their historic average, making them potentially undervalued following the latest falls. The French market pointed at even greater opportunities based on this measure. The Japanese market had a higher CAPE by year-end, although it was lower than its historic average.
That seems to echo investors’ sentiment, with the BofA Merrill Lynch Fund Manager Survey in January reporting that European and Japanese stock markets have retained the most popular spot. Prospects for emerging markets could prove stormier, however, due to a combination of greater exposure to falling commodity prices, and more sensitivity to rising US dollar and Fed rates, with the survey highlighting record level of pessimism about emerging markets equities.
The overall direction going forward, at least among the major markets in the developed economies, could therefore be upward this year, especially given the sizable corrections we have seen so far. However, there could be some complications.
One worry - for economists at least - is that the turmoil in financial markets could feed into economic activity, with lower household confidence hitting consumer spending and lower business confidence curtailing investment plans. Such dynamics could trigger a self-fulfilling cycle of both financial and economic downturn. So far there is little evidence of this, but more prolonged falls across markets could bring it on.
Another possible vulnerability is the continued focus of many governments on putting their houses in order, with fiscal prudence overriding support for economic recovery, and central banks left to hold the baton as guardians of growth with few tools at their disposal. Ultimately, fiscal policy may need to be cajoled in order to sustain a prolonged rally, but the ability of a sprinkle of central bank magic to lift markets’ spirits should not be underestimated.
In the short term, brace yourself for continued market volatility.