12 October 2018
What to make of the current sell-off in equity markets? A bear market has taken shape in the emerging markets in US dollar terms, if defined as a 20 per cent fall from highs. Europe is not quite there, and everywhere else has so far seen a relatively modest correction.
Important to be vigilant
Our operating assumption remains that the global economy is pretty strong and equity markets are relatively attractively valued with a supportive profit outlook. However, in light of the recent sell-off, it is important to be vigilant and watch the current apparent risks very closely while keeping the focus on stock selection rather than macro forecasting.
We have had several pullbacks in the past 10 years since the financial crisis, all of which were in some way justifiable and left investors feeling bruised and nervous. But markets by their nature settle down to find an equilibrium where the positive and negative forces are back in balance, and this normally happens quite quickly.
Different from February fall
Back in February, concerns about US inflation triggered a technical sell off in which the S&P 500 Index fell by 10 per cent. Six straight sessions of falls brought the S&P around 7 per cent off its recent high. But the magnitude of some individual stock declines has spooked some investors, so it is worthy of comment.
This decline is somewhat different from the February fall, which was really just a strange type of stop-loss tailspin that hit specialised exchange traded funds (ETFs) in particular. October’s sell-off is being blamed on a spike in US bond yields but the underlying causes go a bit beyond that. This is an issue that is centred on the US - even if, as is often the case in times like this, other markets have borne the brunt of the impact.
Consider what has happened to US interest rates this year: the Federal Reserve raised its benchmark rate to 2.25 per cent from 1.50 per cent, and 10-year bond yields have risen a similar amount to around 3.15 per cent from 2.40 per cent. The current correction is largely a spasmodic adjustment by equities to higher rates and ostensibly tighter monetary conditions in the US.
Genuine reasons for concern
Meanwhile the US economy is very strong, growing at an annualised rate of 4.2 per cent in the second quarter. Likewise, US corporate earnings have surprised even the most optimistic expectations from last year. This momentum is expected to have continued into the third quarter, with strategists predicting Q3 reported earnings per share in the US to increase around 25 per cent compared with the same period last year. That is a big jump, compared with much more modest rise in the S&P 500 index of 9 per cent over the past 12 months. So in relation to prevailing company profits, US equities - and all other markets for that matter - are significantly cheaper today than they were a year ago.
However, there are some genuine reasons for concern in relation to corporate earnings. Some telling profit warnings in recent weeks have highlighted growing challenges for companies. The coming earnings results season will add more colour to this picture and highlight those areas where - for now, at least - profit margins might have peaked.
On top of this, we should certainly pay attention to current weakness in demand from China and cost inflation. This is unfortunately bound up with government policy, and the impact of tariffs on trade and import prices, which is irritatingly unpredictable.
Source: Bloomberg, October 2018
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