When markets tumble the collective need for a clear explanation becomes overwhelming. People who are usually indifferent to the performance of stocks suddenly want answers as a sharp slide in markets is on the news.
This week has certainly cemented October’s reputation as a dangerous month for equities, as Wall Street erased its gains for the year in a tumble on Wednesday. That only compounds what is already a miserable 2018 for many other global stock markets: the FTSE All-World index — with a US weighting of 31 per cent — is on course for its worst month since 2012.
In just five weeks, Wall Street has swung from a record peak towards correction territory, or a drop of 10 per cent from a recent high. Wall Street bounced on Thursday, but disappointments from Google and Amazon will turn the screw on equities again. It is not hard to find reasons why the once seemingly impervious US share market is falling into line with the less than stellar showing by equities elsewhere.
Higher bond yields are getting some of the blame. Then there’s mounting evidence of how Sino-US trade friction, a stronger dollar and weaker global growth is hurting companies — highlighted this week by two industrial bellwethers, Caterpillar and 3M. This has seen investors latch on to the narrative that US corporate earnings have peaked and that the tailwind from tax cuts will duly fade. Put bluntly, this means valuations are unsustainable as earnings are seen falling next year, triggering a messy adjustment on Wall Street that affects global investor sentiment.
If they could draw up a wish list, investors would see more stimulus from an already heavily indebted China and a resolution over trade with the US. Add in a budget agreement between Brussels and Italy and a Brexit deal. And any sign that the Federal Reserve may pause in its interest rate rises, thereby undercutting the dollar, would be the icing on the risk party cake.
While such developments are feasible, the current tension in markets reflects a more profound change: the end of central banks’ decade-long suppression of bond yields and volatility. The US has been at the vanguard as a stronger dollar and higher funding costs — the three-month Treasury bill is around 2.3 per cent — have rippled across the world. Just look at emerging market equities that today trade at their steepest discount versus developed world shares in price-to-book terms.
The end of central bank support for asset prices is gathering pace. At the start of October, the European Central Bank reduced its monthly buying of bonds to €15bn and this week affirmed the end of quantitative easing in December. The Fed is reducing its balance sheet at the maximum pace of $50bn a month and is on track to continue raising overnight interest rates. Make no mistake, it will take a much bigger market shock — and one with the power to seriously hurt the US economy — to make the Fed pause.
All of which means the magical formula of recent years that has relied on buying dips, selling volatility and sticking with the herd via passive investment strategies looks in trouble. The very poor performance of shares of asset managers after their banner run during the QE era is one place to see these fears are crystallising.
One key development for investors is how the rout in US shares this week at one point crushed the S&P 500’s total return, leaving it close to 1 per cent from a peak of 12 per cent in September. Historically, the ballast that helped offset periods of poor performance of equities has been to own long-dated government bonds. Not this year. The problem for many portfolios is that long-dated US Treasuries show a total return of minus 7.8 per cent for 2018.
And in spite of the pain in US stocks, Treasury yields remain near their recent peaks — something that reflects the less appealing aspect of US leadership. The US economy remains robust, but fiscal largesse like the tax cuts needs to be paid for through hefty sales of Treasury bills, notes and bonds. As Citi’s fixed income team notes, the final quarter of 2018 will see Treasury debt sales in the region of $350bn, more than a third of yearly supply.
We are in the first stage of a period in which investment returns will become more challenging, which will be exacerbated if the long-running relationship between bonds and equities breaks down or at the very least becomes blurred. KKR thinks a “secular shift in asset allocation” beckons as stimulus shifts from monetary towards fiscal.
The downside of higher deficits is a more volatile environment for equities, but that should be good for active managers and stock pickers. It’s far less cheery news for autopilot strategies using exchange traded funds.
Once the current selling pressure abates, investors will return to what worked before. We are still some way from a true bear market that marks the end of every cycle, but generating strong equity performance is going to be harder from here.