Many markets around the world have already corrected as much as 20% to 30%.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- Everyone seems to be looking for the next recession—and the next bear market—but what if both already happened?
- The global economy has been slowing for a year and a half in what can be termed an "industrial recession," and many stock markets have declined 20% to 30%, either in price or valuation or both.
- Stock markets can correct in many ways, from price drawdowns to valuation de-ratings to simply lagging their respective long-term trend lines. For the past 21 months, global equities have done all three.
- Based on price patterns since 2009, one could make the argument that stocks are ready to break out to the upside once again.
Financial markets around the world have been struggling with numerous crosscurrents, as evidenced by the almost 2-year holding pattern for most equity indexes. Since its valuation peak in January 2018, the S&P 500® price-only index has gained a mere 5%, about half the average gain of a normal year. Worse, the MSCI All Country World Index (ACWI) has fallen 3% in the same 21-month time span.
After a year and three-quarters of sideways, we may well be getting to that point where the market declares itself in one direction or another: Either we break out of late-cycle purgatory and start making consistent new highs, or we enter a bear market.
Fed to the rescue?
The global slowdown, already underway, is being met with more and more monetary stimulus. The only questions on investors' minds are whether this slowdown is morphing into a recession and, if so, whether the monetary response from the European Central Bank—and now also the US Federal Reserve—will be enough to stop it.
Now that the Fed has delivered its third rate cut of 2019, the odds of a fourth before year-end have dropped to about 1 in 4. The market's hunger for future cuts may subside even more in light of the recent announcement that the Fed plans to buy $60 billion or more worth of Treasury bills per month to address the market's liquidity needs. (Fed Chair Jerome Powell added: "This is not QE [quantitative easing]. In no sense is this QE.") Indeed, just recently the forward interest rate curve indicated a reduction in the expected number of interest rate cuts, shifting from 3 or 4 cuts down to 2 or 3 cuts over the next few years, although I believe the change is more likely the result of de-escalation in the US-China trade dispute over the past few weeks.
Will this third cut to the interest rate plus billions of dollars of monthly T-bill purchases be enough? The Fed seems to think so, given that it only reluctantly went along with the market's demand for policy easing. Hopes at the Fed seem to be for a repeat of the midcycle adjustments of 1995 and 1998. Likewise, the stock market appears to be following that analog pretty closely, and the yield curve has started to "dis-invert," with shorter rates now lower than longer ones. In my view, that is a good thing.
The stakes are high
The US economy is now in the sub-50 zone in the Purchasing Managers' Index* (PMI), where the odds historically have favored bottom fishing, with investors trying to hook "undervalued" securities before they spurt higher. In the past, when the PMI fell below 50, the S&P 500's 12-month forward return turned compelling more often than not—with a positive showing 10 out of 15 times since the 1950s, by my count. The problem is that at those times when the turn didn't come quickly, it ended up coming from much lower levels. Investors can really get hurt when trying to catch a falling knife.
Earnings growth in the US has slowed almost to zero—and, for the rest of the world, remains in negative territory. As the Q3 earnings season kicks into high gear, I'm interested to see whether the fourth quarter follows in the footsteps of first and second. During those earlier quarters, the growth estimate started the earnings season around –3% to –4%, only to end up just above zero once enough companies beat their previously lowered guidance.
As of this writing, the Q3 estimate sits at roughly –3.7% with around 200 S&P 500 companies reporting so far. Meanwhile, the calendar 2019 estimate is closing in on 1% (down from 1.9% a week or so ago and 2.3% a week before that) and the 2020 estimate is above 10%. Of course, that 2020 number involves some downside risk if the usual Q4 estimate's downward drift continues.
Trying to determine when the next recession will strike and to what degree it will knock the stock market remains a favorite pastime of just about everyone these days—and for good reason. After a 10-year quintupling in the S&P 500 price index (counting from its March 2009 low), uncertainty certainly seems high. Investors have been waiting for the "big one" for some time now.
Bear market ahead—or behind?
What if we are waiting for something that has already happened? What if the bear market already ambled by?
With the S&P 500 hitting yet another all-time high, that may seem like a silly thing to ask, but the fact is that many other markets have been in a 21-month-long correction in terms of price, time, or valuation. A correction can be measured in more ways than one. A sudden drawdown of 20% or more is the most traditional, of course—and by the way, such a drawdown took place in the fourth quarter of 2018.
But one also can look at stock valuations or measures of time, i.e., how long the market has lagged its long-term trend. On the valuation side, many forward price-earnings (P/E) ratios around the world have suffered drawdowns of 25% to 30% from the January 2018 valuation peak.
That's a meaningful haircut, and one could easily make the case that this constitutes a bear market in and of itself. P/E ratios have been under pressure for almost 2 years, with China and the other emerging markets leading the way to the downside with 30% drawdowns.
In the past, non-US equities (both developed- and emerging-market) generally outperformed the US stock market when the global cycle recovered or accelerated. We aren't seeing that yet, but with a "skinny" deal on US-China trade seeming likely, not to mention a potential Brexit resolution, perhaps the global animal spirits will revive.
In terms of trend, the chart below compares the total return (price plus dividend gains) of the MSCI All Country World Index (ACWI) against its trend line since the 2009 low. The bottom panel shows the MSCI ACWI's P/E ratio over time, as well as the index's deviation from its P/E trend line. As you can see, the market is in a constant state of flux, like a pendulum swinging from above trend to below and back both from a price and valuation perspective. It rarely just sits there on the trend line.
What's ahead?
So, over the past 10 years or so, we observe a clear pattern of the stock market rallying hard (i.e., with a slope greater than the trend line), then stalling out for a number of months, then finding its footing again to stage another run, and so on. The result is that we have a fairly harmonious-looking pattern of advances followed by consolidations/corrections. The 2009–2010 run led to the 2011 correction (including a 21% drawdown), the 2012–2014 up years proceeded to the 2015–2016 down years (with 2 declines of 15%), and the 2016–2017 rally led to the 2018–2019 correction (20% decline). This pattern of strong advances followed by shallow, time-based corrections fits well with the narrative that we remain, in fact, in a secular bull market that could last many more years.
The chart above also highlights that these last 3 time-and-price corrections took the MSCI ACWI from around 10% to 15% above its trend line to 10% to 15% below trend. Based solely on the index's harmonious wave pattern, it seems to me that we could be about to embark upon another bull leg. After last week's US-China trade thaw—or at least potential thaw—along with renewed "not-QE" asset purchases from the Fed, perhaps we now have a narrative to support an upward breakout. Of course, for this narrative to play out, we have to assume that other headwinds begin to resolve and no new ones emerge. If so, the market may well look past any Q3 earnings misses toward a brighter 2020.
About Jurrien Timmer
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
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