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Stocks Fall: Why Now, What’s Next?

Key Points

  • Bond yields may need to pause for stocks to find their footing

  • Growth remains strong and the pullbacks are likely to be temporary.

  • Increased volatility and the advanced stage of the business cycle mean that staying globally diversified and frequently rebalancing back to target allocations are important.

What happened? Last week was the worst week for global stocks since early 2016 when fears of a sharp slowdown in China’s growth shook world markets and bond yields plunged. Now, the catalyst isn’t fear of a growth slowdown, it is fear of too much growth and surging bond yields. An overheating global economy could mean a more rapid shift by central banks to rein in stimulus, often a precursor to a recession and a bear market.

That was then, this is now

Global yields

Source: Charles Schwab, Bloomberg data as of 2/2/2018.

Why now? Market pullbacks always have a catalyst—but they typically aren’t the only reason stocks fall, just the straw that broke the market’s back. In this case, the recent rise in optimism among business leaders and investors along with 15 straight months without a stock market decline (among other risks noted in our recent commentary: Five Global Risks for Investors in 2018) had left the global stock market vulnerable to a pullback. Last week’s slide was triggered by the sharp rise in global interest rates and signs in Friday’s U.S. employment report that the Fed may need to be more aggressive.

It isn’t unusual to see pullbacks, even those that are more severe than last week’s move. In fact, global stocks have fallen from peak-to-trough by more than 10% in two-thirds of the years since 1979, yet most of those times still posted a gain for the year, as you can see in the chart below.

Declines are common and usually don’t mean losses for the year

MSCI World Index returns

Past performance is no guarantee of future results.
Source: Charles Schwab, Factset data as of 2/2/2018.

What’s next? If early 2016 serves as a guide, when rates continued to move stocks continued to fall, suggesting bond yields may need to pause for stocks to find their footing. Another way to think about it is that the stock market slide in the past week brought the performance about halfway back toward the late cycle average, suggesting the potential for some further downside. The stock market, as represented by the MSCI World Index, seems to have been tracking the average path of stocks during the 130 weeks leading up to the past six global recessions, as you can see in the chart below. Recently, stocks had climbed above the average, but still were well within the range of the past 6 cycles noted by the shaded area, suggesting the move wasn’t extreme.

Global stocks tracking average late cycle performance

Stocks tracking average

Performance measured by MSCI World Index for the six global recessions since inception of index in December 1969.
Past performance is no guarantee of future results.
Source: Charles Schwab, Factset data as of 2/2/2018.

The current downturn in stocks may be limited to just a pullback, since rising inflation is not usually a major negative for stocks. While higher yields make bonds more attractive relative to other asset classes and can lift the cost of debt and wages for businesses, usually the rise in inflation is due to stronger growth that also lifts earnings despite a rise in some costs, as you can see in the chart below of the Eurozone. The related rise in interest rates can help too since the biggest contributor to earnings for global companies is the financial sector, where earnings tend to benefit from higher interest rates and the steeper yield curve that resulted from last week’s moves.

Earnings tend to track inflation

EZ MSCI Index vs CPI

Source: Charles Schwab, Bloomberg data as of 2/2/2018.

Earnings growth has been a key support for stocks and has continued to climb with analysts making more positive than negative revisions to their estimates even through last week, as you can see in the chart below. In fact, we haven’t seen such a strong pace of upward adjustments to earnings for global companies since the rebound from the global recession of 2008-09. It’s worth noting that isn’t just the U.S. tax cut driving those upward adjustments, since we are seeing them across the globe. It is good to see both actual and expected earnings helping to justify the recent rise in optimism of business leaders and investors.

Analysts are raising earnings forecasts after years of lowering them

Analysts upward EPS revisions

Chart depicts upward less downward earnings per share estimate revisions by analysts divided by the total number of revisions for companies in MSCI World Index.
Source: Charles Schwab, Factset data as of 2/2/2018.

What to do? Growth remains strong and the pullbacks this year are likely to be temporary. Increased volatility and the advanced stage of the business cycle mean that staying globally diversified and frequently rebalancing back to target allocations are important in 2018.

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The MSCI World Index captures large and mid cap representation across 23 Developed Markets countries. With 1,653 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI Euro Index captures large cap representation across the 10 Developed Markets countries in the EMU. With 122 constituents, the index covers approximately 70% of the free float-adjusted market capitalization of the EMU.

©2018 Charles Schwab & Co., Inc. All rights reserved. Member SIPC.