Global Macro & Strategy

Strategy: where are we at? Is this mini correction the start of something bigger?

UPDATED 13/10/2021: S&P 500 is currently -4.06% down from its recent high, Nasdaq is down -5.95%, and ASX200 is down -4.61%.

Global share markets are in the midst of a mini correction here, with (at the time of writing) the S&P 500 down around -4.15% from its recent high, the Nasdaq down around -5.43% from its high, and the ASX 200 down around -5.86% from its high. After such a long run of grinding gains over the past year, the inevitable question arises, is this the start of something bigger and should we be worried?

No surprise

First of all lets just say that the current bit of elevated volatility and market turbulence should be no surprise at all to our members, as we have been saying for a number of weeks now (and quoting directly from the weekly Portfolio Strategy Summary) “…. we are now in the part of the cycle where we are at risk of intermittent garden variety corrections to share markets to shake out some excesses”.

How is this any different from before ?

The question that gets raised from the above statement is, aren’t we always at risk of a correction ? Technically this is true, as any external shock event or narrative can cause uncertainty and result in short term upheaval in financial markets, however history shows us that narrative driven falls don’t tend to last if the data does not support it. It also shows us that there are times in the cycle where corrections are much more probable, and times when they aren’t.

For example, when PMIs are coming off very low levels and are rising (i.e. the economy is recovering AFTER a significant downturn, having bottomed and is accelerating upwards), historically the risk of a correction is low, and the risk of a new bear market / crash etc is very low. The new upcycle is the part of the cycle where share markets have some of their best gains. In fact, it has been quantified that while PMIs are rising the share market generally puts in approximately 75% of its ultimate gains for the cycle, compared to only around 25% after the cycle peak. Rising PMIs are also where cyclical and higher beta/risk assets tend to do well. We call this the “risk on” part of the cycle.

However, once the business cycle starts to peak (and potentially even stay elevated and crab sideways for a while), things start to change. Returns from the market slow down, and rotation out of cyclical assets and into more ‘secular growth’ assets start to take place. Its not that the economy has turned bad or has stopped growing. Its just not as good, and hence investors turn to those assets that can still grow even as the economy comes off the boil. Its also where intermittent corrections start to occur. We call this the “risk rising” part of the cycle.

As the cycle continues and those elevated PMI readings eventually start to actually fall as growth continues to slow, then this focus on secular growth continues, and risk starts to incrementally rise. If accompanied by falling bond yields (which it often is) then interest rate sensitive assets such as bonds and the ‘bond proxies’ (think REITS and Infrastructure etc) also do well as their prices tend to be inversely correlated with bond yields. Overall, the share market still tends to do OK – just not as good as before- and there are distinct winners and losers. It’s the so called stock pickers market, where positive earnings revisions get rewarded. This is still part of the ‘risk rising’ part of the cycle mentioned above, and short term corrections come and go.

However, as this downtrend continues and PMIs start to approach the 50 level (above 50 is expansion, below is contraction) then we tend to see risk and volatility rise more significantly. If the downward trajectory continues and PMIs actually fall below 50 signifying actual economic contraction, this is the big “risk off” phase of the market where the nastier bear markets lurk. It is actually the expectations of an earnings contraction that is the catalyst, which just happens to occur right around when the ISM crosses the 50 threshold. It’s a good example of how the macro flows into the micro. This is the wealth destruction part of the cycle that investors generally want to avoid. We call this the “risk off” part of the cycle.

So where are we now?

Take a look at the chart below of the ISM Manufacturing PMI (a proxy for the US business cycle. Note we follow the US cycle the most as it has the most bearing on US and Aussie share market performance). The orange line is the ISM, and the blue line is our multi-factor forward model that attempts to plot a probable course based on previous stimulus or tightening in the system that acts on a lag to the real economy.

Note how the steep fall of the ISM in March 2020 was accentuated by COVID (note the slowdown was already happening), and the subsequent steep rise has been accentuated by the extraordinary amount of both monetary and fiscal stimulus that has been thrown at the US economy.

That point aside, we can see that the ISM has just come off multi-year highs, and is still at a high nominal level, indicating that economic growth is still strong. The orange ISM line chart may give the impression – when viewed on its own – that the peak is in. Indeed, this is how the markets have been trading lately, and is part of the reason why we started warning in the weekly strategy update that correction risk was now a thing.

However, the blue line in the above chart (our forward model) is saying, hang on, not quite so fast. This model suggests that ‘COVID stimulus juice’ aside, some more previous stimulus in the system is about to hit the real economy and help the cycle along for one more leap higher into year end. The latest move higher in the ISM appears right on cue. This in fact jives well with other quantitative macro modelling we use that is anticipating a bounce in both US and Global high frequency growth data over the final quarter of the year, which may indeed give the reflation trade a final run. So in other words, although the correction risk had risen (and we’ve had thus far a mini version) the odds are actually with investors that this is a short term thing and some more positive tailwinds are about to kick in. So we are in that final transition phase between ‘risk on’ and ‘risk rising’.

Come early 2022 however (and indeed all through 2022), it’s a different ball game as it appears the ‘risk rising’ part of the cycle will be predominating, and moving towards ‘risk off’ later in the year. We’ll cross that bridge as we get to it. There are a variety of factors that make 2022 a higher risk proposition than 2021 (in particular the prospect of the Fed tightening into a slowdown due to persistently high inflation – NOT GOOD), and we will cover those issues in future updates.

Could this correction get worse short term?

Yep, sure it can. Anything can happen. The narrative around the US debt ceiling and all the political brinkmanship (nonsense) around it could easily drag on. We’ve also got the Evergrande issue in China still percolating, and a range of other negative narratives to keep the glass half empty. Plus from a seasonality perspective, October is historically (in aggregate) the worst month of the year for volatility.

However as we have permanently printed at the top of the weekly Portfolio Strategy Update, “in the short term the market can be a narrative machine, but in the medium to longer term, it is a data weighing machine. So if you are a medium to longer term investor, be aware of the narratives, but focus more on the data with an eye on the risk monitor. Specifically, where we are in the business cycle and where we are likely headed.”

Wildcards right now are US wages growth (CLICK HERE for more on that) and rising bond yields, with persistently high inflation readings and surging commodity prices that are asking serious questions of the Fed’s insistence that inflation is ‘transitory’. Rising bond yields are not so much the issue, it’s the rate at which it happens. Sharp rises in the US 10 year bond yield over short periods of time can upset the market, especially mega cap tech, which of course is now a large part of the index. Having said that, if growth data does indeed accelerate over the next few months then this will ameliorate that to some extent.

The bottom line

Corrections can be scary, because you don’t know how deep they will go. However, using a logical, data driven framework that provides us with a probabilistic view to the future based on history and the evidence at hand, helps us to navigate these storms and take a considered view as to when its prudent to push on, or when its time to take safe harbour. On all the evidence at hand, we suggest that the current correction is thus far of the ‘garden variety’ that we have been warning can pop up in this part of the cycle. Short term, negative narratives could take this correction a bit further, and if bond yields and/or wages growth rise too quickly they will also likely have a negative effect. However medium to longer term investors can take some comfort in the fact that it is historically unlikely that we are at the start of a big nasty protracted bear market that normally happens when PMIs (and hence earnings growth estimates) approach the contraction level. We are nowhere near that right now, however as we move into 2022 we will have a different set of variables and risks to contend with. Stay tuned.  (Members can stay up to date via the weekly Portfolio Strategy Updates in the members research portal).


Author: Graham Parkes
Macro analyst & editor of The SMSF Investor

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