- As of the close of October 29th, US equity markets have now strongly corrected from the all-time highs reached around the last investment committee on September 24th.
- The S&P 500, Dow Jones are all negative this month – to the closing of October 29th ---9.4% and -7.6% respectively, and the NASDQ and the Russell 2000 are strongly negative, -12.4% and -12.9%, too. All major US equity indices are unchanged or slightly negative year to date.
- The resilience in the equity markets because of the late cycle extension that we discussed in the last investment committee, ended abruptly in October. Month to date the S&P 500 is down -9.4%, the worst month since February 2009 and has erased the gains for the year. With the moves last week of -4.5% in the S&P 500, 2018 has now witnessed 4 instances of 3% or larger moves in SPX – all on the downside – which hasn’t happened since 2011, and the VIX has crossed above 25. The -4.6% selloff in the Nasdaq on Wednesday, October 24th, was also the worst one day move since 2011.
- Two weeks ago, this “rolling bear market” made its latest and perhaps loudest statement yet by attacking this bull market's darlings — growth stocks, concentrated in the US Technology and Consumer Discretionary sectors. $10 trillion has come out of US stocks in the last month (up to October 26th). The rolling bear market has now hit virtually every major asset class.
- Buying the S&P 500 after a month like this, relative to buying after the market rallied, was a profitable strategy from 2005 to 2017. However, in 2018, its returns have been negative for the first time in 13 years.
- This shift in market structure is driven by: 1) QE has ended and global central banks are withdrawing liquidity (less cheap money available to buy assets), 2) earnings growth is set to slow from recent tax-cut fueled highs and 3) poor performance and volatility is limiting risk appetite. But the dynamic that will ultimately convince investors to stop buying the dip is performance. P&L for active managers has been poor, which limits risk appetite, particularly at this time of year. The deterioration in ‘buy the dip’ also extends to shorter time horizons, with the market seeing relatively larger ‘gaps’ and momentum during the trading day. At the end of the day ‘buying the dip’ is very similar to ‘liquidity provisioning’ and a decline in one leads to a decline in the other. None of this is to say that equities can’t bounce sharply on short covering from current oversold conditions – the point is simply that bounces going forward are more likely to be short-lived and should be sold into rather than chased and this week was a prime example as short lived bounces.
- Regarding the bull versus bear market debate: what remains unclear to us is if this volatility is the reaction to market dynamics or a deeper and fundamental sentiment shift that signals the end of the “bull market that everyone loves to hate”.
- In this post-Global Financial Crisis world, the market has had access to plenty of easy money through quantitative easing and unique monetary conditions from the Fed. Again with the analogies, it is like the market is the patient and the Fed is providing the medicine. With the end of easy money swiftly approaching, can the patient finally be off the medicine and feel well and healthy on its own?
- On the positive side, the US economic fundamentals still appear strong, with strong 3Q GDP on Friday October 26th – growth came in at 3.5% vs. 3.3%. However, one can argue that this number works against equities as Powell will be inclined to continue its tightening process. Nevertheless, rates have come in, the yield curve is steady again at around 30bps (10 year minus 2 year), oil prices are staying cheap and passing on benefits to the consumer, and merger arb spreads have held. Buybacks also remain hugely important, as there is a lag between big EPS days, and when those companies are actually in the market.
- While the market felt vulnerable last week, the start of buybacks will be an important tailwind (i.e., vitamins for the patient). And not to mention, earnings have been generally supportive with the preponderance of US companies beating expectations. On the other hand, price action last week and the severe market reaction following fears about tightening financial conditions, the China slowdown, trade/tariff concerns, geopolitical uncertainty, dollar liquidity moving out of the market and concerns around margins all push the bears to believe the patient is not yet ready to be weaned off its medicine.
- Many investors were hoping that earnings would be the push the patient needed. As this past week was the biggest yet for US earnings, with 35% of the S&P 500 market cap reporting numbers, it was an important litmus test that did not pan out as many expected. So far, around 80% of companies have beaten EPS estimates for 3Q 2018. While constructive, this earnings season has not been the remedy many were hoping for. Good earnings were met with a proverbial “yawn”, while bad earnings were aggressively sold as there was no patience for anything but meaningful beats and upward forward guidance.
- Market bellwether Alphabet (GOOGL) stands out as one of such companies. GOOGL’s earnings were good but the revenue misses overshadowed what seemed like a strong earnings print, epitomizing the underlying fear of a market slowdown by investors. Earnings day price performance has continued to track below the historical average, as significant de-risking and P&L preservation appear to be the main culprits pressuring the market multiple. On a relative basis, larger-cap companies have had better luck in terms of earnings day price performance, outperforming the market by +6bps vs. underperformance of -53bps for the rest of the SPX.
Europe, Japan and Emerging Markets
- European markets have strongly corrected since last month, but slightly less than the US markets. The MSCI Europe is -7% mtd and -8.5% ytd, and the Eurostoxx -7.2% mtd and -10% ytd. However, Europe continues to capture attention with geopolitical headlines, with the UK and Italy stealing the show. Arguably, the Italian Budget and Brexit are the two biggest macro hurdles for investors to get over before we can start to see flows back into European equities. On the risk front, Italy released its fiscal plans by announcing a deficit of 2.4% of GDP next year. Though within the prescribed EU limit of 3% of GDP, the proposals rattled the markets, who fear the anti-establishment parties are not committed to tackling the Italian debt pile, which at about 130% of GDP is the biggest in the Eurozone behind Greece. In addition, the Eurozone has requested that Italy revises its budget, which has been refused by the Italian coalition. Brexit remains an ongoing discussion between the Eurozone and the UK government without a deal in sight.
- Ongoing disappointment in the Euro area has continued with Euro area growth forecasts steadily cut since the start of this year, and a sharp fall in the flash PMI for October pointed to further downside risk (it moved to a level consistent with roughly 1.5% GDP growth, compared with 1.75% fourth-quarter projection).
- The underlying drivers of euro area growth do not seem to have changed much, but a combination of political uncertainty, disruptions to the region’s large automobile manufacturing sector, and worries about the outlook for global trade and emerging markets activity may be weighing on the economy more persistently than we had expected.
- Japanese markets corrected further, with the Topix and the Nikkei both down respectively -11.3% MTD and -11% MTD.
- EM markets continued to collapse with the MSCI Emerging Markets index down -19.3% YTD, as the sentiment toward EM assets remains deeply negative while fundamentals appear much more stronger than in previous periods of stress, particularly when comparing the current episode with that of the taper tantrum in 2013. Most EM economies are less in need of external financing now than back then and their current accounts are much more balanced. While investors have singled out Argentina and Turkey for their imbalances, concern about ensuing contagion seem overdone as EM fundamentals overall do not warrant such a negative approach.
- The exception to the strong EM equity market correction have been the Brazilian and Russian markets, that remain positive for the year, +9.7% Brazilian Bovespa and + for the 9% Russian market.
We view the current equity decline as a correction rather than as a signal of impending recession (and a much larger stock sell-off). That said, with the return on both cash and the expected return on government bonds (as rates are rising) now much less unattractive than before, and with late-cycle dynamics in the U.S. likely to return to investors’ minds fairly regularly, we see fairly low appetite for risk assets going forward. That said, the sell-off has moved the equity risk premium back to the high side of its long-term norm, in our view justifying a small preference for stocks over government bonds. We retain our preference for U.S. equities despite their role in triggering this sell-off, expecting their high-quality nature to assert itself in the event of a more serious and lasting decline. Thus we are recommending to slightly increase the weight in the US equity market and marginally reduce the weighting in European equities.
We observe that the US housing data has taken a turn for the worse in the past several months, with sales dropping off significantly. We attribute the slowdown to this year’s rise in mortgage rates, which occurred when the level of activity in housing had climbed. While housing wobbles raise uncomfortable memories of the Great Recession, we think the economy’s vulnerability to a housing downturn today is much less than in the mid-2000s, and we believe a shrinking housing sector poses only modest downside risk to overall growth expectations.
Uncertainties about China remain. We are expecting policy stimulus to stabilize Chinese growth by the end of this year. September indicators remained soft, and credit data suggest that monetary easing is struggling to gain traction. We still expect the economy to turn the corner in coming months, but any improvement may be faint by the standards of past easing periods.
Although these bits of economic news are unhelpful, we do not find them sufficient to justify this month’s sell-off. Rather, we think slower-moving aspects of the economic environment are to blame, in particular ongoing Fed tightening and prospects for more of the same; a general sense that growth outside the U.S. is subject to downside risk, in part associated with trade war jitters; and worries (partly Fed-related) that the U.S. itself is moving toward the end of its current cycle. Ambiguous forward guidance during the current earnings season appears to have crystallized the latter two concerns.
We continue to believe that U.S. recession risk is low over the coming year and expect that the market will eventually re-focus on a still-solid earnings growth atmosphere. But late-cycle concerns will likely reassert themselves periodically from here, generating period bouts of volatility. What about the effect of the sell-off itself on the economy? Financial conditions have unambiguously tightened in the past several weeks, and they have now unwound the majority of their easing during 2016 and 2017. As such, they have become a neutral-to-negative factor for the 2019 outlook, instead of the tailwind they have represented through most of this year. Moreover, we have not yet heard Fed communication to suggest that the course of monetary policy tightening is likely to change in the near term. While the Federal Open Market Committee will ultimately be sensitive to financial market moves, we think that with the unemployment rate below 4%, inflation at the Fed’s target, and near-term forecasts still calling for above-trend growth, a more significant tightening of financial conditions will be required to alter he Fed’s views.
The probability of a hike in December has fallen slightly, but remains well above 50%. We note, however, two mitigating factors to the financial conditions story. First, the dollar has risen less than might have been expected during the equity market tumble, limiting the headwind to U.S. corporate earnings. Second, the oil price has also fallen sharply, reversing what looked likely to be a significant drag on consumer spending around the turn of the year. More generally, the U.S. economy does not appear to have experienced much of a wealth effect from equity market moves during the current expansion, with the household saving rate holding at a higher level than highly favorable balance sheet conditions would imply.