Stock market volatility

Like many investors, we expected that last year’s winning streak of consecutive monthly gains on the stock market would be unlikely to continue into 2018.

There have been several periods of market volatility since the start of the year for various reasons, including fears of inflationary pressure and trade protectionism, which may have caused a shock for those investors betting on continuing market calm.

However investors expected markets to perform, the stock market’s twists and turns over recent months may have proved unnerving, with the rapidly evolving trade spat between the US and China seeing many turn to the perceived safe haven of the bond market.

Here, we consider some of the potential risks for investors, and how the apparently fractious geopolitical backdrop could impact on global economic growth.

Trade war

The last month has seen US President Donald Trump’s administration turn towards protectionism, meeting its pledges made on the campaign trail.

Proposed US tariffs on China are unwelcome, and the risk of trade tensions developing into something more economically damaging has grown. Yet tariffs announced and threatened by both sides should have relatively little impact on global growth. China’s global exports came to $2.2 trillion in 2017, while US imports from the rest of the world were $1.8 trillion. Even so, the perceived threat of trade wars has become one of the greatest risks for stock markets over recent weeks.

However, we suspect that the threat may be a negotiating tactic on the part of the US administration. President Trump will be looking for a big win to show the electorate before the midterm elections in November. Meanwhile, China cannot afford to look weak, which perhaps explains the rapid and proportionate response to the announcement of punitive US tariffs.

We believe the two sides will likely negotiate to mitigate the risk of an all-out trade war. Nonetheless, China's proportionate response has increased the risk of further sharp rhetoric between the nations over coming weeks, which will no doubt keep the markets jumpy.

Volatile markets

In 2017, the VIX – a popular measure of the stock market's expectation of volatility – experienced 14 of the lowest-ever closes in its 28-year history, so it’s safe to say the year was unusually calm for the stock market. By contrast, the behaviour of markets so far in 2018 represents a sudden return to normality. There are a number of points to draw from this return to potentially volatile markets.

A climate of volatility should bring with it greater opportunity for active managers to outperform the market, by finding those stocks with the potential to weather the current economic and political turbulence and produce long-term returns. This is when active managers should, in theory, earn their fees relative to the ever-increasing array of passive products.

The day-to-day swings in stock markets should also serve as a healthy reminder that no one is able to accurately predict market movements. A trade war has been the main concern for investors since US President Donald Trump’s election campaign. Yet those who decided to remain uninvested as a result have missed out on attractive stock market returns since his win, amid accelerating global economic growth.

The prospects for economic growth and, therefore, potential returns, mean we’re still siding with the stock market for the next 6 to 12 months, in spite of the potential for more volatility while the tough talk on trade continues.

The return of inflation

The first signs of stock market volatility this year were in late January. US markets started to correct in response to healthy wage growth in the country, which is widely considered a signal of rising inflation, higher interest rates and, therefore, lower stock market valuations. Yet since then, moderate wage growth has resumed, and investors have shifted their attention to other concerns. Besides, history tells us that the impact of higher wage growth on inflation is a slow and uneven process.

However, there are other reasons why inflation might rise. The recently passed Republican tax cut, alongside the deal to raise US government spending, will add a hefty dose of stimulus to an already healthy economy. The risk of less benign inflation remains, but we believe that if this occurs, it will be further down the line.

In conclusion

Global economic growth is in the process of peaking, and the risk of a trade war may be a few steps closer than it was three months ago. These factors have helped to persuade many to retreat from investing in the stock market, and turn to the perceived safety of the bond market.

In our opinion, these conditions certainly suggest a slower pace of growth for the stock market, but we expect investors will benefit from gains nonetheless. Growth is indeed peaking, but at levels consistent with strong corporate revenue and earnings growth. Meanwhile, the current inflation backdrop isn’t a major cause of concern at present. These factors, alongside our belief that the rhetoric around protectionism will not turn into an outright trade war, keeps us moderately positive on the outlook for the stock market over the next 6 to 12 months.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

Remember, the value of investments can fall as well as rise and you could get back less than you invest.