Coming on the heels of the September rate hike in the US, rising bond yields seemed to be the vampire, drawing blood from the sell-off initially. However, but October’s performance pattern is more consistent with general defensiveness, than increasing interest rates alone. Sector performance highlights the very strong rotation away from growth that we saw last month.
So, what has been spooking markets? There is a long list of concerns for investors. With the Q3 reporting season underway, investors are worried whether US profit growth has peaked for this cycle, especially alongside a softening in global economic growth and the potential for a further drag from the US-China trade war, ultimately hurting company margins. Then there’s the withdrawal of central bank stimulus, which risks upsetting the post-financial crisis landscape for investors. Thrown into the mix are messy geopolitics around Italy, Brexit and US mid-terms.
Should one capitulate and join the bearish train? Recent anxiety tells us more about the market’s risk disposition than a genuine shift in the facts. This could represent a bumpy patch rather than the start of a more prolonged downturn. Arguably the reintroduction of fear and bearish sentiment could be seen as a healthy shake-out and an improvement in the risk-reward for equities. While some late-cycle dynamics are emerging, with the global economy appearing to shift to a lower gear, global growth is still solid enough to support modestly higher inflation and interest rates.
However, with market sentiment falling, there has been intense scrutiny on company results. Investors seem to be ignoring strong Q3 results while being hyper-sensitive to earnings guidance. With economic growth still solid, investors are much more focused on margin compression, which could lead to lower earnings growth even against a backdrop of strong top-line growth. There are two key sources of risks for margins: the effect of tariffs and an increase in labour inflation, should companies be unable to pass these on to consumers. Good news has been met with a sharp rally and every disappointment with a sell-off. So far, more companies are beating earnings estimates than missing, but guidance has been more negative, this has spooked expectations! Fundamentals remain strong, but there are questions about earnings growth from here.
Creeping bear forces have released air from what many assumed were bubble-like valuations. Valuation multiples have de-rated to 2016 levels across major regions and should provide some cushion to equities in the event of earnings downgrades ahead. The correlation between equities and bonds remains firmly negative and the yield gap between the two is still significant, suggesting equities look attractively valued relative to bonds.
Market volatility should be expected in the latter stages of a cycle. The bull market may be long in the tooth, but at this late stage in the cycle, stock dispersion increases, and returns are likely to be driven by earnings. Given a whole host of factors buffeting investor sentiment, it’s becoming a stock pickers’ market!
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.