TECHnical Fragility

09 Avril 2018 Par Valentijn van Nieuwenhuijzen
Valentijn van Nieuwenhuijzen
(Photo: NN Investment Partners)

Markets remain fragile. So far it is more the return of volatility than the generation of returns that describes market behaviour. Noisy politics, rising fears over trade conflicts and negative news flow over the technology sector are fighting for the headlines and are probably contributing to more market instability.

In previous years, however, plenty of troubling (geo)political and corporate news stories passed by (think of Brexit, the election of Trump, Chinese FX policy changes, escalating Russia-West tensions, financial sector regulation, fuel scandals, fears of energy sector defaults) but they never really undermined the upward trend in risky assets.

So, be cautious to worry too much too fast. Often markets shake off the negative headlines and continue their upward path if underlying fundamentals continue to improve. In recent years, the economic recovery only broadened across sectors and regions and helped to create a pretty persistent upward trend in economic data and corporate earnings. This created an underlying resilience in the rising market trend, despite pockets of political or corporate sector turmoil.

Now this is where some uncertainty is emerging. The global economy is still in its best state in over a decade, but for the first time in years it might no longer be improving. At least the pace of improvement is moderating. Our Global Cycle Indicator (GCI), which captures over 70 household and corporate surveys globally, is now showing for the first time since September 2016 that business cycle momentum is no longer improving compared to three months ago (see Figure 1).

Figure 1: Business cycle momentum is no longer improving

 

Given the importance of the support from further improvement, this may explain why recently the market has become more exposed to risk factors stemming from politics or headwinds for the technology sector. In this respect it is important to note that the period between 2014 and late 2016, in which the 3-month change of our GCI was fluctuating around zero with substantial periods in negative territory, was also a challenging one for equities. Only from the second half of 2016 onwards, when more convincing signs of cyclical strengthening became visible, did equities continue their upward trend again.

With less protection from the direction of change in the underlying fundamentals, investor emotion and behaviour become more important for the near-term direction of the market. To profile how that is evolving we use Big Data information on digital news flow (newswires, blogs, financial news platforms, etc.) to capture investor emotion for different asset classes. As Figure 2 shows, the emotion over global equity markets has deteriorated a lot since early March and is now at its weakest level since at least early 2017. An important part of this deterioration stems from the trouble in technology space, where rising probabilities of more stringent regulation and taxation are coinciding with company-specific negative headlines around data security, privacy, and public attacks by US President Trump on the shape of business models, are weighing on sentiment around the most loved sector for investors over the last year or so.

 

Figure 2: Global equity market emotion has deteriorated sharply

 

Moreover, our Big Data-driven monitor of political sentiment has also moved sharply lower recently, and has dropped below previous lows during the Brexit vote or the Trump election (see Figure 3). A key aspect here is probably that (negative) policy action is now seen next to more protectionist or inward looking political voices. Key here obviously are the signs that trade tariffs are being built up between the US and China. How big the tangibility of these actions will be remains very much to be seen, but the fact alone that we are moving from words to policy implementation is clearly already weighing on sentiment of professional investors and market pundits.

Figure 3: Political sentiment has dropped significantly

 

How lasting and severe the consequences of the current market fragility will prove to be depends very much on the degree to which investor sentiment will influence sentiment of households and companies in the real economy. At this point, the overall strength in the underlying economy, the high level of confidence of consumers and firms, and only very limited tightening of financial conditions suggests that a derailment of the current business cycle is unlikely. At the same time it is also too early to be convinced that the market correction has already ran its course if one takes into account the marginal change in economic indicators and the short-term evolution of investor emotion and political sentiment.

 

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