The S&P 500, the Dow, the NASDAQ and the Russell 2000 are all negative this month, to the closing of December 19th. Year to date: Dow -5.65%, S&P 500 -6.23%, NASDAQ -3.86% and Russell 2000 -12.1%.
- As mentioned in last month’s IC, a wave of bad news have hit US equities over the past three months. Certain market strategists are obsessing over the odds of a coming recession, and in some cases bears are outnumbering bulls. The question we ask ourselves is, was it merely bad luck that so many bad things happened all at once? Or is something wrong in the financial and economic system that could tip the sharp selloff since late September into a bear market?
- The answer may be a combination of both. Bad things happen all the time, but when there’s nothing deep to worry about, they have little wider effect. On the face of it, the U.S. market should be fine. Earnings have remained strong. The economy has been doing well, and economists’ forecasts for this year and next year have been upgraded slightly since the start of last month, according to several publications we follow. Valuations are still high by historical standards, but the forward price-earnings ratio for the S&P 500 is back down to where it stood in the summer of 2014, at 15x, after reaching a 16-year high in January.
- So why have markets felt so heavy? Because there were headlines, many headlines. Geopolitical noise is weighing on investors and companies, creating an overall feeling of uncertainty and volatility. More specifically: Chief of Staff transition in the White House, Muller investigation leading to convictions, Federal Reserve uncertainty, China summoning the US Ambassador on Huawei, riots in France, and the Trump Organization under further scrutiny, etc… and more recently a looming government shutdown. So yet again, geopolitical risk seem to be the one concern on the laundry list that is unresolved. Those are just a few of the types of headlines the market was happy to ignore not too long ago. We are at a geopolitical tipping point, with many countries turning inward, one could argue we are seeing this in China looking to their 2025 plan, as well as Brexit, and France. This uncertainty is hindering global collaboration and worrying investors and corporates as they pull back risk.
- The sense, short term, is that the end of 2018 will end on a negative to neutral note, as opposed to a “Santa Claus Rally” that many were wishing for. There are only so many days left in the year, and many are wounded from a P&L perspective and hurting from mental exhaustion. Thus investors ultimately need to see a clear path to visibility on this geopolitical landscape that could be hard to find in the remaining weeks of 2018.
- However, I encourage all to think of the big picture. While day-to-day market conditions have been a source of pain for many, it seems to me that, regardless, investors are very much in the “love my stocks but hate the market” state of mind. In my view, the calendar effect is very salient for many investors given the year we have had, with the average fund hurting into year-end. I'm sure many are looking forward to having time to reflect, reset and relax during the holidays after a long year.
- For the broader market, the biggest change to market environment is the US Federal Reserve’s rate increases and shrinking balance sheet. Yesterday’s Fed decision to raise rates by 0.25% to 2.5%, the fourth rise this year, was already discounted and market participants were expecting a dovish message. In addition Powell also pared back its forecasts for further increases and indicated that it is less certain about future moves.
- Chairman Jerome Powell thought that was what he delivered, with policy makers now forecasting only two interest-rate hikes next year, not the three they expected in September. Powell added that the federal funds rate is within the range of estimates of what is considered neutral, which neither stimulates nor constrains the economy. However what spooked the market was the explanation he gave about the Fed’s balance sheet, and the policy of QT, or quantitative tightening. Powell said this:
“We came to the decision that we would have the balance sheet run-off on automatic pilot and use rate policy as the active tool of monetary policy. I don’t see us changing that.” Implicit in this response was Powell’s belief that the steady move to reduce the Fed’s balance sheet assets and, hence, mop up liquidity, was not going to roil the markets. For some reason, he had not said this quite so bluntly before, and judging by the market’s reaction, investors did not think that this was the plan. The result was that equities sold off and the bond market suprisingly rallyed. The 10 year T-Bond is now trading at a 2.75% yield, the 2 year at 2.66% and the 5 year at 2.63% yield; an extremely flat yield curve.
- This flat yield curve offers no great hope for banks, which traditionally derive much of their profit from the gap between low short-term rates and higher long-term rates. A flat curve tends to imply a fear that rates will rise in the short run, it could also be taken as a measure of the market’s fear of a hawkish mistake by the Fed. But the underlying message of the stock market is still emphatically that the Fed is wrong, and that the chances of an imminent downturn are increasing.
- The market and the Fed are at odds. At this point, it’s not clear who deserves to win. Powell seems to have badly misjudged the level of anxiety in markets about QT and the effect it’s having on liquidity. The markets seem to be moving to discount an imminent recession in a far more extreme way than anything in the data currently supports.
- Who could be upset by this turn of events? It turns out almost anyone owning U.S. stocks. Meanwhile, anyone who had a long position in bonds did nicely. Bonds were supposed to be in a bear market, and for good reason. As early as October the mood was bearish, with 10 year yields at levels of 3.3%. The economy is growing, there are reasonable worries about faster inflation and there are enormous concerns about whether the bond market can digest the enormous borrowing by Uncle Sam to finance a bulging budget deficit created by an unfunded tax cut.
- With short term rates at 2.5%, as mentioned last month, the Fed is a worry for two reasons: first, because companies have been borrowing heavily, second, as a result of the Fed rate increases, cash is now a much more attractive alternative to stocks.
- Probably the recent volatility is healthy, finally shaking the equity market out of the lethargy caused by the «goldilocks» post-crisis environment.
- This all has investors moving into a new regime of lower returns, because economic and earnings growth and the housing market are all slowing while corporate leverage is high.
- We are inclined toward the positive in the medium term. The froth has blown off tech stocks, the U.S. economy has yet to show any signs of trouble, and there has been a correction in the S&P. Discussing with several of the money managers we invest with they are saying that they seldomly have seen their top holdings so cheap relative to their forward looking earnings expectations, or what they also call imbedded returns.
- For active managers, there might be a little good news in the fact that as many as 200 of the 500 stocks in the S&P 500 have avoided losses for the year. There’s dispersion and volatility, so managers with skill may be able to prove their stock picking skills going forward.
- This all means that we are more likely heading into a period of low returns with more volatility, as opposed to a sustainable bear market.
- No doubt there has been a lot of damage to the investor psyche these past three months. Investors were struggling to keep pace when US markets were hitting all-time highs in September. Over the last 10 plus weeks, they haven’t been able to adjust as quickly as hoped. At this point, the equity correction has hurt sentiment meaningfully. This is demonstrated by the recent degrossing we have been witnessing in hedge funds (equity long/short). As we are approaching the 40% net long percentile as an average, this net exposure is near YTD and post-financial crisis lows for a couple weeks now.
- Yet many of the items that have caused investor worries have been addressed:
- Oil is meaningfully alleviating inflation / consumer impact fears
- US 10 year yields approaching 2.75% from the ominous 3.3% level from early October
- Complacency fears are no longer there as volatility has spiked and exposures have been cut
- Globally and finally in the US, multiples have contracted by 25-30%
- The FED has marginally been more “data dependent”, dovish and predictable.
Europe, Japan and Emerging Markets
- European markets have also continued correcting since last month. The MSCI Europe is -12.09% YTD, and the Eurostoxx -12.9% YTD. However, Europe has continued to capture attention with geopolitical headlines, with the UK, France and Italy leading the headlines. Arguably, the Italian Budget and Brexit are the two biggest macro hurdles for investors. After Italy released its fiscal plans by announcing a deficit of 2.4% of GDP next year, there has been a formal request from the Eurozone for Italy to revise its budget. The Italian debt pile, which at about 130% of GDP is the biggest in the Eurozone behind Greece. In the past days it seems that the Italian coalition is perhaps willing to review the budget. This could be positive news. In France the “gilets jaunes” (yellow vests) movement has forced the government to announce increased government spending and has created havoc on many sectors of the economy. On the Brexit front the Eurozone has agreed a Brexit deal with the UK government. Now the difficult part begins, which is approving the Brexit deal in the UK. The discussion of a second referendum is creating passionate debates and even more uncertainty.
- Ongoing disappointment in the Euro area has continued with growth forecasts steadily cut since the start of this year, led by falls in the PMIs and expected growth.
- 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.
- As mentioned earlier the following items are also positive for Europe as well as for Japan and the EM markets:
- The oil price correction of over 40% since September will help alleviate businesses and consumers
- German Bund 10 year yields at levels of 0.22%, continue to be at historical lows even though the ECB is ending its QE
- Complacency fears are no longer there as volatility has spiked and exposures have been cut
- Globally multiples have contracted by at least 25%
- The ECB has announced the end of QE for this December, but strong doubts remain if they will increase rates in 2019
- Japanese markets continued correcting, with the Nikkei and the Topix both down respectively -8.76% MTD and -9.01% MTD; and -10.4% YTD and -16.5% YTD.
- EM markets have stabilized this month with the MSCI Emerging Markets index down -16.47% YTD, as the sentiment toward EM assets seems to be stabilizing from a very negative period. 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 in less 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.
We view the current equity decline as a correction rather than as a signal of impending recession. 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.
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.
China’s economy is struggling with a slowdown in lending even before the extra hit from U.S. tariffs. On top of that, the economies of Germany and Japan both shrank in the third quarter, although economists put this down to one-off effects of new auto emissions rules in Europe and natural disasters in Japan.
Coupled with the ECB ending its bond-buying, this quantitative tightening is one of the main causes of a broad reappraisal of the market regime.
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 US itself is moving toward the end of its current cycle.
We continue to believe that US 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 periods of volatility, like what we have seen in October, November and December. 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, the Fed continues to suggest that the course of monetary policy tightening is not 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.
We don’t subscribe to the idea that investors should be increasing their fixed income allocation and duration, yet. From a tactical point of view investors have moved to bonds as they have reduced their equity allocations, however the higher deficits in the US and the continuation of QT, and the end of QE in Europe, make the long end vulnerable to more volatility.