Market opinion is divided - here’s why

This article was originally published in The Telegraph.

AT the start of every quarter, I sit down to pick the brains of my smartest colleagues and contacts and then try to condense their thoughts into a half coherent market outlook. I trust they won’t take it the wrong way when I say that this time around, I’m still grasping for the ‘story’. I can’t remember a time when so many clever people have disagreed about so much and had conviction in so little.

Investors are a bit rabbit in the headlights right now. And that is showing up in a couple of key ways. First, they are buying an awful lot of protection against the possibility of a big market slump. Trading in options based on the Volatility Index (VIX) - a kind of collision insurance for investors - has soared by 40% this year. With a quarter of the year still to go, volumes are already ahead of the previous record in 2017.

Secondly, investors are increasingly saying they don’t want to make either the positive bet on shares or the more pessimistic one on bonds. They are instead just putting their money into cash and enjoying a 5% return with almost no risk to their capital beyond the obvious erosion of value from still high inflation. In the past three months, almost ten times as much has flowed into money market funds as into either US shares or bonds.

Since the start of the pandemic, markets have moved in fairly well-defined trends, but ultimately, they haven’t really gone anywhere.

Goldman Sachs describes this as a ‘Fat and Flat’ market which neatly captures the idea of apparently big moves that in the end leave you back where you started. One of my US colleagues, more poetically, characterises it as ‘after the ecstasy, the laundry’ - he means that after the market fireworks in 2020 and 2021 we’ve had a couple of years of drift as investors in both bonds and shares have struggled to understand the underlying market direction.

Stock markets slumped when Covid arrived in March 2020. Almost immediately they then responded to the fiscal and monetary bazookas that governments fired around the world and rose strongly until the end of 2021. When that combo re-ignited long-dormant inflation and central banks turned the interest rate screws, investors went into their shells again. Until, finally, they started to look through the monetary squeeze last October and galloped ahead until the middle of this summer, when it feels like they lost their nerve once more.

Four clear market phases and what looks like the start of a fifth, all of which have largely been driven by growth, inflation and interest rate expectations. We’ve all become obsessive central bank watchers over the past three and a half years and it’s not surprising therefore that the Fed’s higher-for-longer warning a couple of weeks ago has been the proximate cause of the latest wobble.

But stand back a bit from those clearly explicable zigs and zags and the bigger picture is harder to grasp. The S&P 500 is back where it was two years ago and it is only there because of the remarkable performance of a handful of giant, defensive tech stocks. An equal weighted index of America’s leading companies has been going sideways for even longer. And a measure of the US’s smaller companies has been in retreat for three years now.

The big unknown is whether or not we are heading into a recession, and this is where the main disagreements arise among my clever friends. For much of 2022 the outlook was deteriorating on all fronts. Growth was ebbing away, inflation was rising and, with it, interest rates. Recession seemed like a sensible base case. This year, the market has dared to hope that the landing might be softer. Recession fears have abated. Then, more recently, higher-for-longer projections for interest rates have made it seem likely that the lagged impact of tighter monetary policy has been delayed not cancelled.

And that is why since the start of 2022 most markets remain well under water. Japan is the exception that proves the rule, having been out of favour for so long that apparently real changes in how companies think about their shareholders and the end of 30 years of deflation have finally given investors a reason to believe.

In real, inflation-adjusted terms, US, European and Asian stocks are around a fifth lower than they were 18 months ago. Because the main indices are skewed towards the better performance of a handful of big stocks (on both sides of the Atlantic; less so in Asia) that slide has been disguised. The biggest 15 companies in the US, for example, are up by a third so far this year (and the biggest five by nearly 40%). But strip out technology and the market is only 3% higher. The average stock has barely risen at all.

This is why the recession question is so key. Stock markets are neither particularly expensive nor very cheap, in most cases. The focus is, therefore, what happens to corporate earnings, because if they grow as forecast in 2024 and 2025 then so too can the overall market.

In the absence of a recession, earnings rarely fall much so it matters who is right - the bottom-up analysts who are still hearing positive noises from companies or the top-down strategists who fret that two years of aggressive rate hikes are about to smack us in the face.

The good news is that while we wait to find out, the risk/reward balance of bonds looks more and more compelling with an attractive yield today and the prospect of a capital gain tomorrow as and when interest rates start to come down again. And 5% on cash doesn’t take much thinking about either.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.