Romain Boscher, Global CIO Equities
A welcome rebalancing of risk
The magnitude of October’s market swings exceeded our expectations, but we do not think they heralded the turning point of the cycle. In fact, they reflected an overdue reassessment of risk in the system, and a healthy rebalancing of risk premia that took some of the heat out off assets that were priced for perfection in favour of those that had languished.
Scratch just a little beneath the surface, and it soon becomes clear that there has been a significant rotation from growth to value assets, from ultra-large cap to smaller assets, and from momentum to more contrarian strategies.
Most significantly, of course, this affected the FAANGs - those young but huge technology-fuelled companies that have dominated US market growth (Facebook, Apple, Amazon, Netflix, Google). Their valuation gap with the wider market had grown to extremes and was not sustainable. The bull market’s breadth had to increase as the gap between the median and the average valuation had soared, and the average valuation had become misleading.
The correction hasn’t quite led to a value call yet in the US, where valuations are more or less in line with long-term averages. But elsewhere the market’s sudden correction has created attractive opportunities among stocks that are now priced too cheaply compared to their fundamentals and historical trends.
Dividend yields are now even more attractive
As the fiscal impetus fades next year and tighter financial conditions work their way through the economy, the US Federal Reserve will struggle to implement many more rate hikes. This means that long-term interest rates will not rise significantly from current levels, plateauing just above three per cent in the US. Elsewhere in the developed world, of course, they remain (much) lower than that.
This leaves dividends looking attractive compared to bond yields, particularly after the unusually homogenous 8-10 per cent drop in equity markets globally in October. The correction pushed dividend yields even higher while bond yields hardly moved, and boosted the equity risk premium, which was already significant.
Earnings continue to support equity markets - just a little less so
It is easy to forget when screaming headlines appear to have lost all sense of perspective, but for equity markets, earnings per share (EPS) remains in the driving seat. That makes the outlook for earnings the key question for investors.
Reassuringly, earnings forecasts have not significantly changed despite the sharp correction. This indicates that the market’s reaction was somewhat exaggerated.
Additionally, market volatility levels had been almost too low, leading to distortions. The volatility in the correction wasn’t exceptional, but marked a return to more normal levels from a historical perspective.
Investors remain composed; the risk is in the unknown
Investor behaviour remained remarkably constructive throughout the correction. There was no switch to panic mode (which so often leads to selling at market lows and buying at peak levels). Investors have grown more mature, and in today’s low-yield environment are more inclined to maintain their equity exposure. In addition, all markets were dragged down to a comparable degree, including the US which usually act as the safe haven in turbulence. As a result, there were no significant outflows, which are typical of panic phases.
As the correction has run its course, the only real risk now is the unexpected. It’s not Brexit, which we know is an uncertainty and which is priced as such. In fact, the risk from Brexit may well be to the upside because of the market’s fearful pricing. It’s not Italy either, whose problems are all too familiar.
The real risk is China. Depending on your view, China’s outlook could either be reassuring for global equity markets if the authorities manages to engineer a soft landing, or the reason for a considerably more cautious stance if they don’t and economic growth crashes to the ground.
We are cautiously optimistic that a hard landing can be avoided, but recent economic indicators confirm that growth is still heading south and may well disappoint given the latest negative surprises. We would hope to see more constructive news in the next few months but will need to keep a close eye on developments in China.
Steve Ellis, Global CIO Fixed Income[i]
Mixed signals from the credit market
The credit market was resilient to weakness in equity markets through October, outperforming on a beta-adjusted basis. To some extent, this was unsurprising given the relative underperformance of credit year-to-date, relatively light supply and cautious investor positioning.
Interestingly, periods of significant equity market weakness have typically been foreshadowed by drifts wider in spreads, but whether widening of spreads in 2018 will be a precursor to something more sinister is unclear.
Rising rates less of a concern…
Rising interest rates in the US and the Fed’s withdrawal of liquidity have been feeding volatility, as evident in the fortunes of emerging market debt. But the outlook is turning more supportive particularly for US government debt. Maintaining moderate duration exposure can help to hedge against any weakness in risky assets.
Slowing US growth is likely to keep the Federal Reserve in check as the economy responds to tightening financial conditions, a waning fiscal impulse and tariffs dampening demand. We expect the Fed to pause in mid-2019, following three more hikes that will leave the upper-bound Fed Funds rate at 3.0 per cent. This should keep Treasury yields relatively anchored around 3.0-3.25 per cent.
The European Central Bank may also find its hands tied. Faced with a slowing economy, low core inflation and elevated political risks from Italy and Brexit, we expect it to refrain from any interest rate lift-off in 2019.
…But spreads to widen further
Cooling global growth and elevated corporate leverage hardly make for an ideal combination for credit markets, and we would expect global spreads to push wider. This calls for a defensive stance in credit.
That said, pockets of value are appearing in emerging markets and Europe. In Europe, investment grade and high yield valuations have improved to the extent that they offer a compelling alternative to USD counterparts, both on a hedged-yield and spread-to-government-yield basis. With the ending of the ECB’s purchases of corporate debt largely in the price, a benign policy rate backdrop combined with steady growth should keep European credit markets anchored over the coming year.
In emerging markets, 2018 has seen value reappear across currencies, spreads and local duration. Any signs of a pause in Fed tightening and easing of US dollar strength would help to place a floor under these assets.
James Bateman, CIO Multi Asset
Tech giants are impossible to value
Ten years into the bull run, the US market’s breadth had narrowed dramatically; more recently, the market’s momentum had been led by the FAANGs. It’s no secret that this was never sustainable and would always correct at some point, resulting in a period of concern and consolidation.
Markets have a tendency to reappraise risk in September or October, perhaps as people come back a little more rational and focussed from their holidays. October’s correction represented just such a reappraisal of the momentum trade, and I think we could well see this rumble on for longer.
One reason is that it’s nearly impossible to value these FAANG stocks accurately. Amazon, for instance, is both a business services company with its cloud computing division, and a distribution business. If it ends up being the largest player in the world in both of those, it would be worth vastly more than it is now. On the other hand, the lifecycle of companies is much shorter in the technology-led sphere than elsewhere, and it is relatively easy to enter and out-compete an incumbent. Were the Amazons or Netflixes of this world to face such disruption, their terminal value could drop to nothing in 10 or 15 years’ time. This disparity between best-case and worst-case valuations means repeated bouts of FAANG-induced volatility are probable.
Correcting dislocations leads to volatility
Multiple dislocations are also contributing to rising volatility in global markets. The largest of these is the gap between stock market returns (asset owner returns) and worker returns (wages). In the past decade, returns to asset owners have been phenomenal, but increases in returns to labour virtually zero, because wages have stayed flat. In a historical context, that dislocation is highly unusual, making it likely either that wages will rise substantially or asset prices will fall - or both.
A smaller, but nonetheless significant, dislocation is evident in the US market’s outperformance relative to the rest of world. In a world of true multi-national corporations, it is hard to justify different valuations merely because of a company’s domicile. While US tax cuts have unquestionably helped to drive US valuations higher, they do not alone explain the premium attached to US corporations.
The final dislocation is that between stocks perceived to be interesting and those seen as dull. A large part of the bull market has been fuelled by stocks regarded as growth stocks (both quality and technology-related) while cyclical value stocks exposed to the economy’s more traditional sectors underperformed. This has come as a surprise, after years of decent macro-economic data and a still-benign environment (even if there are early signals that growth may be slowing).
The market’s reappraisal of risk may indicate a change in leadership from ‘hot’ stocks to the less exciting stocks - and perhaps atypically, the final leg of this bull market will be in these traditionally less exciting names.
Too early to reduce risk drastically
Our base case is a cautiously optimistic one, that we will see another leg of the bull market. This is partly because the irrational exuberance that normally typifies the end of a bull market has been all but absent (excluding, of course, the FAANGs). In addition, there are considerable amounts of cash sitting on the sidelines that could come back into the market when valuations appear attractive.
This is why we think it is too early to retreat into highly defensive positioning. We have been advocating a neutral equities stance since the summer on concerns about the pace of momentum and narrowness in markets, combined with an overweight to cash and an underweight to fixed income. We believe that remains appropriate, but would look for opportunities to increase equity allocations while also increasing hedges through long duration fixed income.
Given that our core view calls for further gains in US equity markets, there may come an attractive time to reengage with US equities, maybe in traditional value areas of the market rather than in the growth stocks that drove the earlier parts of the rally. Financials could be the exception to this rotation due to their own idiosyncratic issues - some financial stocks may be the value trap of this cycle.
We are also waiting for an entry point in emerging market debt, which bore the brunt of the sell-off as general market sentiment deteriorated. Many investors worried that Turkey’s struggles might ultimately prove systemic rather than idiosyncratic. We don’t believe there is such systemic risk in today’s emerging markets if the traditional headwinds of a strong US dollar begin to unwind. But we think emerging market debt looks more interesting than emerging market equity, because of the yield cushion and the market’s position in the cycle.
With volatility rising, however, we will be increasingly selective with the type of risk we take.
At the margin, long duration fixed income assets can provide some insurance to portfolios, particularly long duration US Treasuries and US TIPS (Treasury Inflation Protected Securities). If wages do catch up with market returns to end that extraordinary dislocation, a period of inflation would be likely.
After years of market beta powering returns, we also think the time is right to rotate a larger share of portfolios into true active management. In late cycle and bear market conditions, active management generally performs better. Strategies that can offer alpha irrespective of market direction, such as long/short equity and other cash-benchmarked strategies, can be particularly attractive in these circumstances.
[i] As of 1 January 2019.
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