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Backdrop
Ten years on from the global financial crisis, October upheld its (somewhat unwarranted) reputation as a rough month for risk assets. Higher US yields and the prospect of further monetary tightening triggered the latest bout of jitters, which intensified as investors began to focus upon corporate earnings in the light of increasing costs and the real impact of trade disputes. Equities fell, high yield credit spreads widened, volatility spiked and safe-havens were sought. Technology stocks led the market down, as deteriorating newsflow and elevated valuations made them obvious targets for profit-taking.
From a macro/political point of view, many of the same worries weighed upon sentiment: US-China trade threats, Brexit struggles and the Italian budget were familiar storylines. Adding to the laundry list of troubles was the political drama in Washington regarding Brett Kavanagh, the Supreme Court nominee, and its impact upon the congressional elections in November. The emerging story of journalist Jamal Khashoggi’s murder also dominated the headlines and heightened tensions with Saudi Arabia.
Policy-wise, the People’s Bank of China loosened monetary policy in efforts to mitigate the effects of the worsening trade war with the US, placing downward pressure on the Chinese yuan. Further measures were also announced with the aim of shoring up the economy. Federal Reserve Chairman Jerome Powell added fuel to investors’ nerves about tightening financial conditions by suggesting that the US is a long way from a neutral interest rate, triggering criticism from President Trump. The Bank of Japan confirmed no change to policy and indicated that the inflation target will not be met for years.
In its World Economic Outlook, the IMF warned that trade wars and tighter credit conditions are darkening the global outlook. In China, the fall in industrial output was blamed on international tensions. The German government slashed its growth forecast, citing trade conflicts and a shortage of skilled workers. Meanwhile, US unemployment reached a 48-year low and the consumer price index climbed, bolstering the case for another interest rate rise in December.
As ever, sterling moves were correlated to Brexit news. The beleaguered currency declined over the month, except against the euro, which weakened in the face of disappointing economic news and political disquiet. The “Brexit in name only” fear from the pro-leave camp moved closer to reality as tensions with Brussels mounted and Tory party in-fighting intensified. UK inflation fell more than expected, also depressing the currency, while UK pay growth rose as the unemployment rate held at 4%. The UK High Street delivered yet more bad news, with Debenhams announcing plans to close stores and alleged fraudulent activities at Patisserie Valerie threatening its future.
Equity markets
Amongst a host of troubles to worry equity investors, the rise in US bond yields was the most damaging to sentiment. The main markets declined in the order of 5-7% in local currency terms; in the UK, large-cap stocks fell by around 5% and mid and smaller-cap stock indices were even weaker. Globally, defensive sectors were in the vanguard, while more cyclical sectors such as retail, autos and energy, as well as software and semi-conductors in the technology space, registered significant weakness. Style-wise, value outperformed growth indices on a relative basis, but that was of limited comfort in the midst of such a negative picture.
In a hostile environment for higher risk assets, there were some stomach-churning falls in some Asian and emerging markets. The Japanese market hit its lowest level in over a year while Chinese markets are experiencing their worst year since 2011. By contrast, the Brazilian market was sharply higher as far right Presidential candidate, Jair Bolsonaro, won a deeply divisive election.
Bond markets
US treasury yields spiked higher early in the month, in the wake of stronger-than-expected employment data. The US 10-year breached 3.20%, the highest since 2011, before retreating rapidly amid equity market weakness. Heavy treasury issuance also took its toll. In the UK, gilt yields followed a similar pattern although by the end of the month, yields had declined, resulting in a positive total return. Higher quality corporate bonds also gained ground, while high yield bond underperformed together with other higher-risk assets.
Commodity markets
After a period of strength for oil, and with commentators musing the return of a $100 p/b price tag, October saw a sharp reversal in an atmosphere of risk aversion and fears of weaker global demand. The gold price rose slightly; despite the difficult month for risk assets, investors are not yet seeking solace in the yellow metal in a significant way.
Final thoughts
At the time of writing, equities continue to swoon, still led by weakness from stocks in the technology sector. Indeed, the S&P 500 index is currently heading for correction territory and has erased its gains for the year. According to Bloomberg, 2018 has been the toughest year to invest since the early 1970s, with the vast majority of markets and asset classes in negative territory. For now, it’s all about “sell the rallies”, rather than “buy the dips”.
As we have cautioned throughout the year, the withdrawal of liquidity from the financial system was never going to be event-free. Recent price action in equity and bond markets reinforces the point that sovereign/high quality bonds are not an automatic sell for a diversified portfolio. Whatever you think about the value of bonds, their role as guardians against further trauma in equities or geo-political events remains valid.
Price action in global equities has followed a familiar pattern, with peripheral markets falling first as liquidity has been withdrawn. As a result, valuations for emerging market equities are attractive on a medium-term view, certainly in relative terms and, increasingly, in absolute term too. European equities continue to dance to the tune of global forces and those anticipating a secular recovery for the European region have once again been bitterly disappointed. Japan has been overlooked, but is arguably the cheapest developed equity market and would benefit from a concerted push by global authorities to ease global liquidity again. The UK market offers value, but remains unloved as it stumbles through the Brexit quagmire. The US market in aggregate is still in expensive territory, despite the recent P/E contraction. Unfortunately for the rest of the world, when the Big Daddy of markets sneezes, we all still catch a cold.
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