by Dominic Rossi, CIO Equities at Fidelity

November 2014

Its an understatement to say that there has been a tremendous increase in volatility on global share markets in recent weeks that is worrying investors. Yet this is not the time to follow the herd and reduce equity allocations.

On the contrary, the US-led bull market is still intact. This is more a healthy mid-cycle correction that should set stocks up for positive returns in 2015. With valuations and dividend yields having become more attractive, this is an opportune time to increase exposure, particularly to the US, which is likely to support global stock markets for a while yet.

The catalyst for what is happening in global equity markets is the strengthening US dollar, which has appreciated significantly against other major currencies in recent months. The issue is that when the worlds reserve currency appreciates, it deflates other assets, particularly commodities such as oil that are priced in US dollars. This is the inverse of what happened from 2003 to 2008 when a weaker US dollar inflated commodities and helped to support emerging markets.

The US dollars appreciation is a result of structural improvements in the US, in particular, the improvements in the countrys fiscal and trade positions over the past few years. While these improvements have been occurring for some time, what has changed is the monetary policy backdrop. Until recently, an environment of loose monetary policy by the Federal Reserve was effectively keeping a lid on the US dollars appreciation.

That ceiling has now been lifted because the ending of quantitative easing in the US and a possible increase in the US cash rate next year coincides with an acceleration of quantitative easing in Europe in Japan. We could be in for a sustained and significant move higher in the US currency.

The rise in the US dollar reflects the fact that financial conditions are tightening. Weve seen the telltale signs building up over recent months and weeks. These include the slump in global stocks, widening credit spreads and an increase in event risk in credit markets, the underperformance of mid- and small-cap sectors since the second quarter and a drop in commodities prices; in particular, a collapse in the cost of oil.

Where are we now?

Investors can be confident that the current five-year-long US equity market bull market has further to run. The US economy is growing at a healthy pace and, importantly, despite five years of quantitative easing, there is little sign of inflationary pressure.

The structural improvements in the twin deficits will support further US dollar appreciation. The collapse of hydrocarbon imports thanks to the US shale revolution has significantly improved the trade deficit, while there is the possibility for further scope for repair. More important has been the improvement in the fiscal deficit, which has shrunk from around 10% at the start of the Obama presidency to around 3% now. The Obama administration has reduced the profligacy of the Bush era and federal outlays have declined as a result of the cessation of two costly wars in Iraq and Afghanistan. As a result, President Barack Obama may well end his presidency with a modest fiscal surplus which will be an impressive turnaround by any standards.

On top of this, the outlook for US earnings also remains positive. Some sceptics have been anticipating a mean reversion in profits. They will be wrong. Profits can stay high, supporting further valuation expansion. Over the past 12 years, we have seen a shift in the distribution of wealth in favour of companies and capital and away from labour. This relationship shows little sign of reversing.

We presently have a glut of savings in the global financial system. With policy interest rates near zero and bond yields at record lows, this wall of money effectively has no pricing power, forcing investors to put their money to work to achieve a decent return. Within a broad global asset class context, dividend-paying equities still look attractive versus other assets such as bonds, and should attract inflows from investors. Indeed, with the S&P 500 Index yielding more than the 10-year US Treasury and European stock markets yielding around 4%, the equity-income story will underpin global stocks.

So which markets will cope best? The US economy will deal with the glut of savings easily. The cases for the sustainability of the US economy, US earnings and US dividend growth remain robust and rising US stocks will help to sustain global equity markets in the course of the next year or so. Although it might be difficult to believe today, the US stock market is likely to rally in 2015 and eclipse the record high it set this year in September.

However, what is good news for the US economy presents a hurdle for other places and this is particularly true of emerging markets. In the last bull market of 2003 to 2008, emerging markets had the benefit of two key tailwinds: the first was the rapid emergence of China and its double-digit economic growth; the second was the debasement of the US dollar and the concurrent rise in commodity prices. The export-led model that worked so successfully for many emerging markets in the past decade has now run aground. Individual emerging markets can only succeed nowadays if they embrace structural reform and successfully adopt a more domestically orientated economic agenda.

Europe appears to be stuck in the middle; on one side, structural challenges remain, real economic growth is hard to come by and credit spreads in the periphery are widening. On the other hand, a weaker euro will be a significant support, particularly in combination with the falling oil prices and weaker commodity prices generally. Together, these factors could give a modest boost to activity in 2015. A lot of foreign money supported a sentiment-driven rally in European markets earlier in the year and a more sober judgement is now being levied. Given the adjustment that has taken place in valuations, Europe is looking as positive as it has for some time.

So investors should not be unnerved by the recent volatility. The bull market in stocks from 2003 to 2008 was about earnings growth, Chinas rise and the resources-based emerging markets benefiting from strong commodity prices thanks, in part, to a weak US dollar. However, todays bull market is about valuation expansion, US leadership and intellectual property sectors like pharmaceuticals, biotech and technology outperforming hard assets against the backdrop of a firmer US dollar. The recent weakness gives investors an opportunity to invest more before the next upswing takes root .

The rebound in the US dollar

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Source: DataStream as at 17 October 2014

Financial information comes from Bloomberg unless stated otherwise.