By Hottinger Investment Management
October saw US Treasury markets finally catch up with reality, in our opinion, and in doing so trigger significant global equity market volatility. The yield on the 10 year US Treasury moved sharply higher from 3.06% to touch 3.23% driven almost entirely by real yields rising because headline inflation fell slightly to 2.3 yoy in October. Financial markets seem to us to have been pricing in half the rate hikes that were currently being suggested by the Fed’s dot plot so it seemed a fair assumption to us at least that a market reaction to a hawkish speech by Governor Powell aimed at jolting markets followed up by reactionary rhetoric from President Trump would see markets react negatively to the potential end of an aging economic cycle. Furthermore, the increased tariff measures from the US administration aimed at China have also triggered a number of US companies to raise concerns over the increasing costs of protectionism. In Europe too trade tensions seem to have affected economic activity with new export orders falling significantly this year and in Germany, in particular, the new car emissions tests seem to have contributed to slowing manufacturing numbers during October in an industry already suffering in the crossfire of the US / China trade war.
As seen in February, a market looking to reduce risk in already extended equity market sectors also went through a significant rotation out of cyclical growth into defensive value. Indeed, despite the prospect of rising rates and bond yields many bond proxy equities showed their flight to quality credentials but another significant factor over late summer has been the value of cash at 2.3% moving above the yield of the S&P500 (1.9%), with investors seeing a modest real return in 2 year Treasuries at 2.9%. For long periods the argument that there is no alternative to equities has led to investors overpaying for growth and potential disruptive technologies that many investors have now become increasingly anxious about this late in the cycle.
However, 3rd quarter US GDP estimates came in stronger than expected at 3.5% qoq driven above consensus expectations by strong consumer spending assisted directly by the fiscal advantages introduced by President Trump. On the global growth front, the picture is clearly mixed. Growth has slowed at the world level from 3.8% over the 2017 calendar year to 3.5% annualized figure for Q3 2018 and has been a negative surprise for markets clearly contributing to the October sell-off. Behind the headline rate, the performance of the European Union and China, which account for about a third of global GDP, have contributed the most to the slowdown, with the central bank in China continuing their policy of monetary easing – going against the grain globally – to support domestic and export activity. On the other hand, the United States, the United Kingdom and Japan are all growing at faster rates than they achieved in 2017, with all countries expanding above 2.5% over the most recent quarter on an annualized basis. In emerging markets, India is strongest expanding by over 8% in Q2 2017 and facing tailwinds from demographics, urbanization and economically favourable policy reforms from the Modi government. Whether India becomes the new China, putting in year after year of 7%+ growth, remains to be seen but the signs suggest it might.
Furthermore, 3rd quarter earnings season has seen 85% of US companies beat EPS estimates so the back drop to the October sell-off was still broadly positive although investors did seem to be focusing more on company forward guidance for signs of possible future slowdown. The possibility that equity investors may have already seen peak earnings during the middle quarters of this year has increasingly caused an air of caution that spilled over in October. As calculated by JP Morgan A.M. the S&P500 moved by more than 1% on a daily basis ten times during October while only managing that feat 8 times in the whole of 2017. The index was down 6.9% on the month leaving it up only 1.4% on the year. The fact that the volatility trigger was an increase in real yields means that the normal negative correlation between bonds and equities also broke down with the Treasury market falling approx. 0.50% in aggregate over the month meaning that multi-asset investors also found it difficult to escape negative markets.
The nature of the correction was felt across all markets with Europe (-6.5%), Japan Nikkei index (-9.1%), UK FTSE All-Share index (-5.4%) and MSCI Emerging Markets (-8.8% in $ terms)all feeling the effects of the risk off sentiment. In fact many global markets found themselves in bear market territory down 20% on the year with only 20% of all asset class types yielding a positive return. The advent of QE brought with it a move away from market fundamentals towards political and central bank influence over investors and, arguably, the existence of a central bank back stop a reduction in volatility that favoured risk assets. As QE turns to QT (quantitative tightening) and economic strength is left to stand on its own feet a return to normal volatility in the latter stages of an economic cycle is to be expected especially if signs begin to show that the economic data is also turning. A return to fundamentals may also see the market signalling system become clearer increasing market opportunities for active investors.
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