Air pocket or capitulation?

The stock market has forecast nine of the last five recessions1. We have little sympathy for the various reasons cited for the recent market correction in the US. Our bias is to add risk in portfolios as soon as we see significantly higher trading volumes and higher market volatility.

20 Oct 2018

The sell-off in the Emerging Markets has spread to the US markets in recent days. At one point2, the S&P 500 and Dow Jones Indices gave up their year to date gains. The breadth of the market correction has been wide. This, in our view, suggests a risk-off environment and is not a recessionary warning.

Market watchers have cited a few reasons for the correction. These include:

  • Rising US yields and continual Federal Reserve (Fed) rate hikes
  • Italian budget negotiations
  • Trade tariffs
  • Peak growth and earnings in the US

Let’s address each of these points. 

  • An unflinching Fed. The Fed continues to focus on the fundamentals of tight labour markets and increased pricing pressures, the dual objectives of their mandate. OECD data shows that the US is enjoying a positive output gap for the first time since 2007. The US yield curve has not steepened much in the last few weeks, with the yields on the 10 and 30-year US Treasuries moving in step with rises at the short end.

    While inflation expectations could cause the yield curve to steepen, we note that inflation expectations as represented by inflation breakeven levels remain steady. See Figure 1. This indicates that investors remain sanguine about inflation. At the same time, investor expectations that the Fed could pause its rate hike cycle are rising. The probability of a December rate hike has fallen to around 70% from a high of 80% earlier in the month. The Multi Asset Solutions team believes that the environment would need to be much worse for the Fed to pause in December.

    Bottom line: Steeper yield curves are a result of a stronger US growth outlook. The Fed is raising rates for the right reasons - driven by the real yield component with inflation expectations remaining anchored. From a multi asset perspective, we are short duration and positive on the US dollar.

  • Italian budget negotiations. This has been rumbling on for several weeks and is a known risk since the Italian elections in May. The European Union Commission has rejected Italy’s budget proposal which would have increased Italy’s debt to GDP ratio and breached the European Union’s budgetary rules. Italian bond yields rose to their highest levels in four years while Moody’s has downgraded Italy’s credit rating to just one notch above “junk”.

    Bottom line: Italian woes are likely to be contained within the Eurozone. The Multi Asset Solutions team is underweight the Eurozone and euro, although we expect the tussle over the budget to be resolved without a major show down.

  • Trade tariffs. In September, the US administration followed through with threats to raise import tariffs on China although it reached a new trade deal with Canada and Mexico in the following month. Various research suggests that the US-China trade tariffs could lower global economic growth by around 0.5%.

    Bottom line. Trade fears are hardly new news and should not trigger renewed volatility in the market. From a multi asset perspective, we are neutral Emerging Market equities although we are positive on Asian High Yields given compelling valuations and the attractive carry.

  • Peak growth and earnings in the US. We have sympathy with this explanation. See Figure 2. US Industrials have highlighted rising costs and lower volumes in the current earnings reporting season. Estimates suggest about tax cuts have lifted earnings growth by 7% in 2018. While the positive impact from tax cuts will fade through 2019, consensus earnings growth forecasts for the US is still healthy, at 10.7%4.

We have less sympathy with the argument that we are in the late cycle of the economy. US financial conditions are not restrictive and real interest rates are still around 0%. The odds of a US recession taking place over the next 12 months is still low. See Figure 3.

Bottom line. Equity markets are currently pricing a different scenario to our core investment road map. With economic and earnings fundamentals still intact, opportunities are emerging. At this point, our process highlights the attractiveness of taking on risk in portfolios, with the balance of probabilities in our favour.

What next? Positioning to buy risk

The stock market has forecast nine of the last five recessions - Paul Samuelson, 1966. From a multi asset perspective, our bias is to add risk, unless inflation expectations become unanchored or the underlying economic activity slows down significantly.

We first, however, need to see either stabilisation or capitulation in the markets. At the point of writing, this would mean significantly higher trading volumes and higher market volatility (VIX). While we note that the Relative Strength Index (RSI) has moved to oversold territory, only 63% of global stocks is in a bear market versus 70% in 2011 and 20166.

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