Equity markets have just undergone a brutal correction across the board. Within two days, the S&P and Nasdaq have lost 5.3%, and markets in China, Taiwan and Europe 3.4%, 6.3% and 3.4% respectively. Outside the United States, annual performances have plummeted by 10.5% to 11.5% in Germany, Italy and Spain, while the CAC 40 is down 3.9%.
What triggered this?
There was no single factor but rather a combination of factors. The Trump administration’s ongoing trade war, political and economic instability in emerging countries, the budget clash between the Italian government and European Commission, Brexit uncertainty and the rise in oil prices all came up against higher US long-term interest rates.
Is the rise in US interest rates recent?
Not at all. Between July 2016 and 21 September 2018 when the S&P 500 reached an all-time high, the US 10-year yield climbed from 1.36% to 3.06%. Despite this 170 bp increase, US markets kept breaking record after record. So it would be paradoxical to place all of the blame on the recent gain of some 20 bps. It is rather the tone and policy of Jerome Powell, who Donald Trump appointed as chairman of the Federal Reserve, that are behind the present situation. Long-term interest rate increases generally result from either fear of an uncontrolled and uncontrollable return of inflation (“the Fed is behind the curve”), or investors factoring in an economic improvement. The latest figures (Q2 GDP +4.1%, inflation + 2.3%, wage growth +2.8%) suggest that it is the second possibility. As such, the rise in long-term interest rates – though lasting – could be limited. It’s the market that was “behind the Fed”, and has suddenly recognized the US central bank’s determination and credibility.
Has the global macroeconomic situation deteriorated?
Not really. Even if the IMF has recently revised global growth downwards from 3.9% to 3.7% for 2018 and 2019, this is still well above the average growth of the last 30 years (3.0%). And while the end of the cycle is drawing to its inevitable close (the second longest US economic growth cycle), the near-term risk of recession seems low or even absent. The Chinese situation looks trickier, though, with outstanding non-performing loans rising year-after-year, eating into future growth. That said, stock markets generally tend to anticipate the end of an economic expansion around a year in advance. So continued growth alongside a market correction is entirely possible.
Are central banks going to intervene?
No. They are committed to ending their QE policies and tapering their balance sheets, and they believe that what we are seeing is a correction to high financial asset prices rather than a systemic shock. Although tighter since the beginning of the year, global financial conditions remain accommodative. Another 10% fall in US markets would render them neutral. (1)
Which sectors and securities have been worst hit?
Although all indices have been badly affected, previously vaunted growth and technology stocks have been worst hit. In just two days, the FANG+ index lost 6%. Momentum stocks have also taken a heavy blow. For example, the S&P Momentum ETF was down 6.3% in two days, its sharpest fall since inception five years ago. Hitherto this year, everything that had been expensive grew more and more expensive every day (technology, luxury goods, etc.) and everything that had been cheap grew cheaper every day (industrials, telecoms, banks, etc.). Until the end of summer, unleveraged growth stocks with dollar exposure were delivering the best performances of any global index; leveraged value stocks more reliant on the domestic cycle suffered greatly. The start of a rapid catch-up effect is starting to emerge in this slump, with style rotation particularly brutal. After lagging by up to 5%, the MSCI Europe Value net return is now matching (-4.7%) the MSCI Growth in YTD terms.
Are prices at knock-down levels?
This can’t be said of the United States, and the answer is much less clear in the eurozone. After the sell-off, European stocks (Stoxx 600) are trading at around 14x forward earnings for 2018 and 12.5x the level for 2019, i.e. slightly less than the historical average for recent years. Earnings growth trends remain healthy at +10% in the eurozone over one year and +25% in the United States. However, the rise in long rates hints at a compression of P/E ratios over the quarters ahead. Furthermore, despite this big correction to equities, the credit market is so far holding out, especially in Europe. What we have is therefore more an adjustment to valuations in a new interest rate environment, than fear of a sudden halt to growth.
But why such a violent correction?
We think that several quantitative and systematic strategies (smart beta, risk parity, volatility target, trend following, etc.) are behind the massive stop-losses seen in the last few days. Traditional management has kept away from this rampant selling. “Technical” conditions are therefore bad for the markets. US firms, which have been big equity buyers in recent years, are also prevented from buying now due to a pre-results blackout running until the end of the month. Bear in mind that as the S&P’s capitalisation was growing by USD 10 trillion over the past five years, US companies were buying around USD 3 trillion of their own shares.
What should we do?
It is still a little early to start reinvesting huge amounts. As was the case in February, market volatility is unlikely to disappear in an instant. However, indiscriminate selling may present opportunities for active management. While we remain convinced that higher long-term interest rates are inevitable, especially in Europe, setting entry prices for unfairly punished stocks is doubtless the best tactic for the weeks ahead. For example, small and mid-cap growth stocks, particularly break models whose profitability is not in doubt thanks to higher interest rates, have now been added to the value segment of the stock selection pool.
Author: Olivier de Berranger, CIO
(1) Pricing the Powell Put – Deutsche Bank, 11 October 2018