You could think of it as the calm before the storm.

A shaky global economy and jittery stock indices are making investors nervous these days. Having barely recovered from a sharp decline on 10 July amid concerns about the financial health of Portuguese lender Banco Espirito, the focus of world’s stock markets has now shifted to record high stock prices and economic weakness in North America, of which the US Federal Reserve warned on Tuesday and the Bank of Canada on Wednesday.

Though this hasn’t triggered a sustained rout in global equities, money managers across the developed world are taking this opportunity to warn investors that markets in North America have been building toward an inevitable slump and that they should brace themselves for as much as a 20% plunge.

A sharp decline of between 5% to 20% or more, called a “correction” in market parlance, would be completely normal given that it’s been nearly three years since the last major pullback, said David Rosenberg, chief economist and strategist at Canadian wealth management firm Gluskin Sheff and Associates Inc.

“In terms of how big a correction, I would say between 5% and 10%,” he said adding that “in this historic period of ultra-low volatility, it will feel more like 20%.”

Jack Ablin, chief investment officer at BMO Harris Bank in Chicago has been predicting a similar downdraft in the US equity market. “A correction is entirely possible, certainly from a valuation perspective [for] the S&P is trading at about 25% above its median price-to-sales ratio” he argued. “A 10% correction isn't out of the question. All major equity markets could be susceptible to a correction.”

An eye on global economies

The view from Europe isn’t any better. Jason Hollands, managing director of business development and communications at Bestinvest Ltd brokerage in London has been urging caution for some months.

“The US market looks particularly expensive,” Hollands said. “The extreme levels of money printing in recent years by the US Federal Reserve and other central banks, combined with ultra-low interest rates, has turbocharged markets and inflated asset prices.”

Globally, central banks have embarked on a journey that will eventually result in more “normal” monetary policy. The Bank of England ended its own Quantitative Easing (asset purchase programme) in 2012, while the Fed has been scaling back its stimulus since the start of this year.

As well, leaders of the world’s most important central banks, including Mark Carney, governor of the Bank of England, and Janet Yellen, head of the US Federal Reserve have been indicating interest rates could start to rise again soon.

Higher interest rates could hurt many S&P 500 companies whose earnings growth in recent years has come, predominantly, from the ability to refinance debt very cheaply.

Hollands said these are indications that “some steam coming out of the pressure cooker is a possibility.” He doesn’t see a stock market crash deeper than 10% but said “when a wild party comes to an end, it'll leave some with a hangover.”

A set of triggers

Triggers for a drastic market correction — such as an interest rate shock and steep stock prices in the US, overheated housing market in Canada, geopolitical events in the Middle East and Ukraine, economic slowdown in emerging markets, and fears of recession in Europe — are all there, yet market volatility (a measure of how widely prices swing) has been eerily low, said Hollands.

“This feels like there’s too much complacency,” he said. “You could think of it as the calm before the storm.”

Increased interconnectedness within key global markets means that the meltdown will likely spill over into other regions, regardless of where it begins. “There's a saying that when America sneezes, the rest of the world catches a cold,” said Hollands. “Were the US market to experience a slide, you might see contagion to other exchanges.”

Similarly, the Greek debt crisis and fears of hard landing in China in the recent past showed that a macroeconomic event can have a knock-on effect on financial markets far from its epicenter.

“All major equity markets could be susceptible to a correction,” said Ablin but asserted that “US small caps appear to be among the most precariously positioned markets now, due to their high valuations.”

Small capitalisation stocks are companies that have revenue of more than $300m but less than $2bn. These companies, said Rosenberg, have been selling for 20 times their earnings versus the historic average of 15 times. Large-cap stocks, companies that are larger than $10bn, have been selling for 15.5 times their earnings relative to the long run average of 13.5 times, he added.

At biggest risk

When US investors panic, they have a tendency to sell the assets they hold overseas and bring their cash home. That means that emerging markets, including Mexico, Turkey and Indonesia, are often the first casualty. Currently, emerging markets appear calm, but Hollands said trouble could be brewing underneath the surface.

“The big risk remains in China,” said Hollands. “Its economic growth rate is slowing, but it has only scratched the surface so far in terms of its need to rebalance its economy away from construction and infrastructure investment and towards the consumer.”

Yet in India, the other key member of the economic bloc, positive macroeconomic data and political developments have kept the market buoyed.

Bengaluru, India-based Kunal Kumar Kundu, vice president and India economist at French financial firm Societe Generale doesn’t foresee a meaningful decline in India.

“The Indian equity market is close to be fairly valued and offers a compelling story supported by relatively high growth and a strong government,” he said. “[India’s new] government is expected to usher in some much-desired reform measures. Within the emerging markets space, India looks a safe bet.”

But things can change pretty quickly in emerging markets. Rosenberg said markets that bear the brunt during turbulent times are generally those that are the riskiest and have the highest beta — a measure of a stock’s risk relative to the overall market. “I would expect emerging markets to suffer the most in a downdraft,” he added.

Andrew Hamlin, vice president and portfolio manager at Aston Hill Asset Management Inc in Toronto said if history repeats itself, a sell-off could be closer than we think.

“Summer months are traditionally slower months for the equity market and August is usually a dreadful month for investors,” he said. “Equity markets in the last three of four years in August have been down months with the smallest down being about 3%. We’re heading into that so there could very well be a sell-off in the market.”

If the correction is sparked by a rate shock or an economic setback, “the sectors most vulnerable would likely be financials, homebuilders, utilities and capital goods,” Rosenberg said.

Ablin said when equity markets tumble, the momentum sectors — lead by technology and consumer discretionaries — could suffer more than others due to a colossal bubble in asset prices.

What should investors do?

It’s time for investors to rebalance their portfolios not just to weather the storm by taking some risk off the table, but also to strategically ramp up or down certain weightings, said Hamlin.

Now, he asserted, is a prime time for investors to take a good look at their holdings.

“If you’ve got some big winners in your portfolio, take some gains by selling them,” he urged. “Don’t be afraid to build a war chest of cash, so when a correction does occur you’re able to buy back your favourite names at cheaper prices.”

Investors should take time to build a shopping list of stocks or bonds they want to own when they get cheaper as a result of market spasms, he added.

As for stock selection, Rosenberg said to focus on high-quality companies with earnings visibility. “We are moving through an era of deflation to reflation to inflation, so I would be hedged by having exposure to energy, gold and basic materials in general,” he said.

When markets fall, investors tend to flee to larger, dividend-generating companies with robust balance sheets. “These are safe-haven blue-chip stocks such as utility companies and tobacco firms,” Hollands said. 

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