Stephanie Flanders: Answering the questions every investor should be asking

Written by: Stephanie Flanders
Investors have understandably started to question whether the core assumptions that have guided their portfolios in the past few years will continue to hold in the future, given the bumps we’ve recently seen in the markets.

We don’t think it’s time for a fundamental rethink quite yet. But there are some key questions hanging over the markets which anyone active in the market will need to consider.

China’s resilience 

The first is whether China and emerging markets will sink the global recovery. Broadly speaking emerging economies are faced with three big challenges: slowing domestic demand, flat or falling world trade, and declining commodity prices.

Some countries are in a stronger position to cope with these difficulties than others. For China, the situation is especially mixed, with the traditional, industrial side of the economy in “hard landing” territory, but the increasingly important services sector – retail, for example – showing a more resilience.

Should we worry that this trouble will spill over into developed markets? Certainly, troubles in EM will pull down global growth and inflation and make life more complicated for the US central bank. We do not think they will derail the moderate economic recovery now under way in the developed world. But it will leave these economies quite dependent on services and consumption to fuel their recoveries – while manufacturing and investment are likely to remain subdued.

Correction or bear market

The second question is whether recent market falls mark a temporary correction – or the start of a full-blown bear market. Corrections are normal and happen most years in equity markets. It’s partly to compensate for these market bumps that equities earn higher long-term returns. But historically, it has taken either a recession or extreme market valuations to trigger a true bear market, where equity prices fall by more than 20%.

Though the picture is weaker than it was a few months ago, we do not see the ingredients for a recession in the developed markets in the near future.  A recession caused by excessive central bank tightening or a big rise in commodity prices seems particularly unlikely, given recent falls in inflation and commodity markets. Nor do we think extreme valuations are about to cause a problem – rather the opposite, given recent sell-offs. Standard valuation measures suggest that the US, Europe and the UK are all close to their long-term average values.  The US S&P500 is now a little below it.

Interest rate rises

The third and highly related question is whether the US Federal Reserve or the Bank of England will ever raise interest rates?

The Fed likes to think it is being communicative. But that rather backfired in September, when it held off raising rates and communicated a lot of confusion about how it would decide policy going forward.

Senior Fed policy makers have continued to speak in terms of a rate rise by the end of the year. But they have found plenty of reasons to delay in the past. There’s no guarantee that they won’t find more, especially with a buildup in inventories in the US raising warning signs about the short-term strength of US demand.

If the recovery in the US and Europe still looks decent in a few months’ time, we would expect the US and the UK central banks to raise rates within the next 6 months – much earlier than the market currently predicts.  But we do not think the UK can act alone.

If the rest of the world is loosening policy and a US rate rise is put on hold, we’d expect the Bank of England to hold off in 2016, and any tightening of conditions in the UK to happen via the exchange rate.

The important point for investors is that the pace of rate increases and the long-term “neutral” policy rate are much more important than the exact date of the first tightening move.  Both are likely to be much lower than in past cycles.

Sorry to say, the same message probably applies to future investor returns. Though we do not expect a full-blown bear market in the near future, we have clearly reached the stage in the cycle when returns are likely to be lower, and to come with larger amounts of volatility. That is especially true in a world that – for all the progress we have seen – is still struggling to deliver “normal” rates of growth and is finding it even more difficult to generate inflation.

Stephanie Flanders is chief market strategist for Europe at J.P. Morgan Asset Management. She is former economics editor for the BBC.

To read Stephanie’s previous blog posts click HERE.

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