The phrase “healthy correction” is among the most frequently used ones in the investment lexicon. It has been ubiquitous over the past few days as a descriptor of the significant falls in global markets. But it is also a puzzling phrase.
First, what does the “healthy” part of the term represent? Falls of more than 4% in a day, with intra-day moves of twice that, did not necessarily come across as being “healthy.” Neither did what looked like computer-generated trading, exacerbated by bouts of forced selling.
Now for the latter part of the term. My first experience of the word “correction” was at school. A correction on the page of your essay meant you had got something wrong. This does not appear to be the definition most users of “healthy correction” are employing this week. Rather, they are thinking that “someone else got it wrong.”
So how should we reflect on a rather eventful week during the early part of February?
It is helpful to remember that last week’s declines have taken many markets back to roughly where they started the year. This is not particularly a disaster, given the rises we have witnessed in recent years. On the flip side of this observation is that there are healthy profits to be had in most risk assets.
We have seen a steady rise in bond yields this year on the back of rising interest rates, stronger growth and inflation; and an expectation that the liquidity tide of quantitative easing (QE) is on the verge of ebbing. This is not a surprise. It has been widely flagged and was expected by many investors.
As U.S. bond yields headed towards 3%, the debate escalated as to what level of risk-free return would start to compete with the returns available from riskier assets. Last week’s market movements appear to suggest that we may have reached a level at which that debate may intensify.
We are in the midst of a period of synchronized global growth.
Economies do not equal stock markets
Last week reminded us that economies are not the same as stock markets. We are in the midst of a period of synchronized global growth. The economic outlook is much rosier than most would have expected just a few quarters ago. Most investors would now share this rosy outlook, but strong economies do not necessarily mean strong stock markets.
This said, investors may be reassured by the strength of company profits, and by the dividends and share buybacks facilitated by high corporate cash flows. U.S. earnings have been particularly strong, and expectations for tax cuts have boosted estimates for this year and beyond.
Inflation is likely to edge higher, but we do not expect it to surge dramatically as structural headwinds remain significant. Accordingly, central banks are unlikely to be aggressive.
The selloff is also a reminder, if any were needed, that risk assets are certainly no longer cheap and are hence vulnerable to “healthy corrections.” The market move served to remind investors to be wary of high valuations, to be wary of high leverage and to value quality. It should encourage them towards diversified portfolios and assets that can survive the “bumps in the road” that we can see. And, more importantly, the “bumps in the road” that we cannot.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).