Q4 Doldrums

Chris Brown, CIO

Global equities are down around -8% for the quarter as we type on Friday 26th October. It is always tempting to theorise about why this should be and we have a couple of good hypotheses for the sell-off below. But it is also worth restating the basic maxim that you earn the money you make in equities by living through events like this, where equities tumble downwards, year to date gains evaporate in a week and everybody is looking around for the explanation. On the long term drawdown and volatility measures we track, this looks like a pretty normal year for equities, and this is a pretty normal event. It is only by comparison to the very quiet 2017 that it feels at all unusual. For longer term investors – which we trust our clients are – nothing has really changed to our longer term outlook.
In the shorter term, though, there are two challenges for markets. The first is a global growth slow down (from admittedly high levels) as we show in Chart 1. This has not really affected the United States but has been felt elsewhere – particularly in the Eurozone and Emerging Markets which were 2017’s economic out-performers. So while the US S&P 500 equity market has continued to power ahead (and is still up a little to date), European equities (measured by the Eurostoxx 50) are down -8% year to date and the MSCI Emerging Markets are off -16%.

The growth slowdown is really a non-US story though and this equity sell-off began in the US markets. While it is possible that slower global growth has finally had an impact on the US equity market (where around half the S&P’s earnings come from overseas) we also need to look for an explanation that is closer to home. The obvious candidate is the impact of rising interest rates. The Fed are on track to get cash rates to around 3% next year. A 3% cash return might well prove tempting in uncertain times and so is slowly sucking cash out of riskier asset markets. The analogy here is of “boiling the frog”. The water has been getting warmer and warmer all year as rates have risen and finally our frog, US equities, has started to notice.

The problem with this theory is, rather like the global growth sell-off, there is nothing I have written here that was not true 5 weeks ago. What has moved in October, however, has been real interest rates – i.e. the return you get over expected inflation. In Chart 2 we show the market 10 year real return for the US. You can see this moving sharply higher in October. Interest rates are broadly unchanged but inflation expectations have fallen – perhaps in line with the growth slowdown. Our best explanation for the recent equity weakness is therefore that they are adjusting to lower growth expectations – particularly for the US.

Where does this leave us? The last time we saw a similar growth slowdown was in 2015/2016, again led by emerging markets and a collapsing oil price. Chinese stimulus and good momentum in developed markets meant that the global economy started to pick up again in 2016 and equity markets rallied with them. We see parallels today: the Chinese authorities are again in (mild) loosening mode and the Eurozone, US and Japan still have good, if not spectacular, growth rates. For now, we see no recession in 2019. One thing that gives us comfort here is the credit markets remain fairly calm. In 2008 credit markets were the early warning signal that the economy was heading for trouble. In 2018, so far at least, this warning signal is not flashing yet.

If we are right on the recession call, this should mean a decent environment for risk assets and equities. Assuming the fundamentals do not deteriorate from here, we would be more likely to add risk if the markets continue to fall. There are a couple of opportunities we are looking at as destinations for this capital. First, UK equities have also had a tough year (down -7% total return year to date). The economy has remained steady and we are hopeful that some of the Brexit uncertainty will lift in the next 6 months. UK equities certainly do not look expensive compared to longer term valuation measures and domestic UK plays should offer some protection against a stronger pound if sterling reacts to a better Brexit environment.

The second opportunity we have written about before but mention here again is emerging markets. The MSCI China Index is now down -30% from its January highs. China is now 15% of global GDP (vs 3.2% for the UK for example) and growing faster than any of the major developed markets. The earnings yield on the MSCI Emerging Markets Index is 9% today. Given the fact that today’s valuations look a little below long term averages and return on capital for EM corporates has recently been improving this 9% yield looks like a realisable longer term return expectation for clients. Today’s pain is, we think, setting up an attractive opportunity for future emerging market gains.