Should investors prepare for an autumn market correction?

There are growing concerns that the tide may be turning. Faith Glasgow examines the main risks that could derail the market recovery. 

After more than a year of market recovery, there are growing concerns that the tide may be turning.

Economies worldwide have seen massive economic and fiscal stimulus worth $30 trillion (£21 trillion) over the past 15 months, as governments have fought to keep them afloat in the face of the crippling impact of the coronavirus pandemic.

Markets have been further underpinned in 2021 as vaccination programmes have been rolled out and investors have become increasingly bullish on prospects for economic recovery.

But in a recent note, Bank of America (BoA) analysts have identified several reasons why markets are likely to see a correction in the third quarter.

First, it’s clear that we’ve not yet beaten coronavirus. Despite more than three billion vaccinations globally in the first half of 2021, rising numbers of Covid cases and especially hospitalisations “will cause downward pressure on 2021 and 2022’s elevated economic expectations”.

In addition, there’s evidence of overheating: for example, the S&P 500 index’s trailing price/earnings ratio is currently sitting at 30x, its highest for a century and twice the long-term average. “The Wall Street boom/bubble needs a breather,” comments BoA.

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At the same time, investors have been piling into risk assets. The BoA analysts report “remarkable inflows” of investor funds into areas such as stocks, financials and infrastructure funds over the first half of 2021. But no one’s jumping out of stocks and into fixed interest, it says; instead, they are turning away from value stocks but favouring US tech.

Rising inflation is also worrying the policymakers who have been pumping money into economies worldwide. The US, Canada, the UK, Australia, New Zealand, Sweden, Norway, Brazil and Russia are among those that could taper or tighten their policies, following China’s recent move to tighten, according to BoA.

At the same time, profits are declining. BoA’s modelling predicts a slowdown in global profit growth from 40% April to less than 20% by August.

Overall, though, the BoA believes “the most obvious reason for a negative third quarter for assets is [anticipation of] a negative fourth quarter for macro (after three or four quarters of stunning, abnormal growth)”.

Gary Potter, co-head of multi-manager at BMO, explains that the market is - as usual - looking to the future, discounting the risk that this year’s recovery will falter into current market values; but he is unfazed by the prospect of a short-term pullback.

“This is nothing out of the ordinary, particularly in the quieter summer months, and it doesn’t necessarily presage a dramatic sell-off in markets,” Potter comments. “Some consolidation would actually be quite healthy.”

He suggests investors are taking the opportunity to “take a breather and take some profits”.

Potter and his team still see wider sentiment as “reasonably encouraging”, although the uncertain outlook for inflation and the fear that it could persist in the face of job and supply shortages are potential concerns.

A correction of 10% lasting six to eight weeks would be “quite within the realms of possibility”, he adds. “Hopefully there will be greater clarity around the inflation debate come the autumn, while any subsequent inflationary shock will be less painful than it would be at current elevated valuations.”

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Thomas Becket, chief investment officer at Punter Southall Wealth, agrees that market complacency reached very high levels in recent weeks. “This has now led to an increasingly significant reversal in markets that was long overdue, and necessary to shake out some of the extended positioning,” he says. 

However, he believes the key question is how long it persists - and that will be dictated by progress in the war against coronavirus.

“Much will depend on how governments choose to act on this latest wave of Covid; hopefully they will decide that vaccinations are doing their job, hospitalisations remain low by comparison to previous waves and death rates will remain at a greatly reduced rate.”

Becket suggests that equity markets have become increasingly worried about the threat of further lockdowns and another winter of discontent, and there could be further downside in prospect. “That is the markets’ biggest fear at this time and explains why we have seen this change in direction.”

But as a general rule, says Kelly Prior, a multi-manager fund manager at BMO, canny investors should stand to benefit from corrections: “No market goes up in a straight line forever, but over the long term, investors should always see volatility as an opportunity to find great investments at great prices.”