Quick View: Market Sell-off, Volatility Strikes Back
Following a sharp sell-off in markets, our portfolio managers share their views on the drivers and implications and discuss the causes of recent volatility.
Jenna Barnard, Co-Head of Strategic Fixed Income
The investing environment in 2018 looks classically late cycle in our mind. Almost textbook! The most recent (possibly final) spike in U.S. 10-year yields in the last month was driven by real yields, not inflation expectations. This, combined with ever more attractive cash rates in the U.S., provides real competition to other asset classes. The equity sell-off in recent days follows a raft of downgrades in more cyclical sectors globally – autos, chemicals, semi-conductors, luxury goods and even packaging and cloud computing. The global growth slowdown, higher bond yields and oil prices is a challenging backdrop for many asset classes.
Andy Jones, Portfolio Manager, Global Equity Income
The past few days have seen a sharp correction in global equity markets, with the S&P 500® Index having its worst day since February 2018. Within the markets, however, there has been significant divergence of performance, with value stocks, overall, meaningfully outperforming growth and momentum on a relative basis. The primary reason for this rotation and overall market sell-off, in our view, is the continued increase in U.S. bond yields. This has been driven by continued robust economic data, and it is important to note that although inflation and rates are rising, we are still at low levels by historical standards.
On a fundamental basis, we would expect economic activity to remain at healthy levels despite concerns over tariffs, trade and political issues in certain countries. This should feed through to continued corporate earnings, cash flow and dividend growth. From a strategy perspective, the best way to navigate uncertain times is to ensure an attractively valued portfolio of stocks. It is also important to be well-diversified. For example, most telecommunications stocks are domestically focused and not typically impacted by trade. Health care companies are also relatively insulated. By continuing to focus on valuation and the dividend-paying capacity of companies, we believe that current market weakness will provide attractive opportunities.
Oliver Blackburn, Portfolio Manager, UK-based Multi-Asset Team
The return of volatility is proving uncomfortable for many market participants. 2017 witnessed only eight daily moves of over 1%, higher or lower, in the S&P 500 Index (see first chart). The figure for 2018 is already far higher and, as we stated at the start of the year, investors are going to have to get used to it. The fundamental backdrop remains solid, although there is admittedly a greater number of risks around than we have seen for a number of years. Flexibility remains key as we negotiate the end of easy monetary policy.
Exhibit 1: Number of Days S&P 500 Index Moved More than +/-1%
Stock markets have had a significant correction in the last few days, led by a sharp move in the U.S. Global equity valuations are now a lot lower than the high point reached in January. This is not out of place as the market cycle matures. The Federal Reserve is raising interest rates and, as the predominant global central bank, the effects are being felt across markets through lower valuations. It is noticeable that yet again an equity market wobble has followed a sharp rise in U.S. Treasury yields as the U.S. central bank tightens monetary policy.
As we move later in the market cycle, corporate earnings growth takes over as the main driver of equity performance. Focusing on the U.S. (which makes up over 55% of global stock market capitalization), companies must deal with a variety of headwinds: rising borrowing costs, increasing salaries, a higher oil price, a strong U.S. dollar and trade tensions. At the same time, the boost from tax cuts and government spending increases will start to wane into the new year. According to IBES estimates from Thomson Reuters Datastream, earnings growth for the S&P 500 Index is expected to be over 20% in 2018, but this is forecast to fall back toward 10% over the next two years. More moderate earnings growth will not be enough to drive the outsized equity market returns of recent years if valuations continue to drift lower.
The technology sector has been at the forefront of U.S. equity market performance this year, particularly once the net is widened to include companies such as Amazon. It is therefore unsurprising that these companies – and the high profile FAANG stocks in particular – are at the center of a market tremor. After a period during which it seemed these companies could do no wrong, there have been a series of negative headlines: privacy issues, security problems and concerns about strategy delivery. After an extended run, a little negativity is taking some of the gloss off these stocks. High valuations had left them vulnerable to a correction as we start the quarterly U.S. reporting season.
Chart 2: Total Return of FANG and S&P 500 Indices (rebased)
However, the broader market moves also bring us back to our view that this year would see the return of greater volatility to global asset prices. 2017 was a year of particularly smooth returns, helped by the last wave of central bank quantitative easing. 2018 has seen the Federal Reserve begin to sell more assets than the European Central Bank is purchasing. At the same time, U.S. interest rates continue to rise. Easy money that soothed investors is starting to ebb away, particularly in the case of U.S. dollars. The effects of a stronger U.S. currency are being felt across financial markets.
We have seen less volatility from all these issues in parts of the market offering better value or higher dividend yields. Strategies targeting lower-volatility equities have also enjoyed out performance. We continue to watch U.S. inflation figures and the Federal Reserve for signs that the pace of interest rate rises may ease. The accompanying fall in bond yields and the U.S. dollar would likely help the stock market reach new highs and ease the pressure on other asset classes. There are a greater number of risks around than in recent years, but we have yet to see signs of the end of the economic cycle, the biggest risk to equity markets.