Having looked at the bull case for stock markets, it is worth examining the bear case. There are structural forces conspiring against equities today, from slowing growth, to high valuations to rising interest rates. We look at why these elements may prove to be the final straw for the lengthy bull run in global share prices.
An environment where inflation rises and growth stagnates looks increasingly plausible. In the UK, for example, the recent growth economic growth figures showed a marked slowing in momentum. Paul Craig, portfolio manager at Quilter Investors, said: “There are sectors still struggling to fire on all cylinders. consumer facing services, which contracted by 0.6% in September, largely as a result of a 13.3% fall in the wholesale and retail trade of cars and a 0.3% contraction in retail sales in September.” Retail sales have now been negative for five months in a row (1.), in spite of high savings rates during the pandemic and apparent pent-up demand.
Inflation is currently running at 2.9% (2.) and the Office for Budget Responsibility says it is likely to peak at 5% next year. Wages are rising, along with energy and materials costs. While central banks continue to insist that these pressures are transitory, they are proving stickier than previously thought.
Stagflation is rare, but is usually bad for markets. Higher inflation slows consumer spending, which depresses company earnings, which increases unemployment. The most egregious example is Japan, where stagflation is embedded and stock markets have struggled to make progress for decades. However, it has happened in the UK, Europe and the US at certain points and remains a possible scenario today.
Aggregate valuations look expensive. A recent note from Deutsche Bank suggested that the S&P 500 is currently around 15% above its historic P/E range. The current price to earnings of the MSCI World is 24x trailing earnings or 19x forward earnings (3.), which also looks high. That said, overall valuations are skewed by lofty prices for the dominant US technology sector (Amazon’s P/E ratio is 68x), which form a significant part of the index. These high multiples are at risk if interest rates rise: any change in the risk-free rate will make these long-term cash flows less valuable.
In reality, bull markets don’t tend to end because of over-valuation and there are plenty of areas where valuations don’t look as high – the UK, for example, or emerging markets. However, these pockets of high valuation make the market more vulnerable to shocks. It also means the fall may be harder when it comes.
Rising interest rates
Interest rate rises still appear to be some way off: the European Central Bank is currently forecasting no rises until 2024; the Federal Reserve isn’t likely to raise rates until mid-2022. Against market expectations, the Bank of England has also deferred a rate rise for now. However, there is an undoubted change in direction: the Federal Reserve has started to reduce its asset purchases and it is clear there are concerns over inflation. The US 10 year treasury yield has risen from lows of 1.15% in August to around 1.6% today (4.).
In general, these changes in monetary policy direction have seldom been achieved without some volatility in markets. The most conspicuous example was the taper tantrum of 2013. The other major risk is that policymakers get it wrong and are forced into a sharper adjustment to interest rates. If the market doesn’t like tapering, it really doesn’t like a hasty rise in interest rates. More than anything else, this has the potential to derail markets today.
Any discussion of a potential bear market needs to come with the caveat that it is usually better to stay invested and wait out market volatility. Also, market exuberance often persists longer than investors expect. However, there are real risks for stock markets today and there may be a bumpier ride ahead.