German bunds, FAANG stocks, global IT and the S&P 500 have managed to deliver modest positive returns year-to-date. But they are the exceptions: most equity markets, government bonds and credit are in negative territory.
This has occurred despite some distinctly positive news. US GDP growth hit 4% annualised in the second quarter, earnings by S&P 500 companies have comfortably beaten expectations all year, rising by 26% in the year to Q3, US taxes were cut by $1.5 trillion and US corporates bought $0.8 trillion of stock. There was good news in other countries too: much attention has been given to US unemployment, which fell to multi-decade lows but the UK, Europe and Japan have enjoyed a similar result. Global earnings per share have hit record highs.
So what has gone wrong?
Several factors are at work but we would highlight US interest rates. The Federal Open Market Committee (FOMC), which sets official US interest rates, has been raising interest rates since December 2015, but the process has been relatively benign, until this year. Indeed, financial conditions, as measured by a broad array of factors had been easing. But that changed following a series of comments by key FOMC members over the summer, which suggested that interest rates might ultimately rise rather further than the market had expected. This led to jitters in the markets.
This is not the only market concern. Political risk in the eurozone has re-emerged. Italy, long regarded as ‘too big to fail’ is currently seeing a standoff between the new government and the EU over Italy’s budget. This has pressured spreads in the periphery and negatively impacted sentiment towards eurozone banks. Brexit has had its principal impact on UK markets, but it has also added to European market nervousness.
Trade tensions have continued and there are increasing concerns over a longer-term strategic shift in relations between the US and China. Trump has previously cited Chinese theft of intellectual property as a key concern and reports of Chinese industrial espionage compromising some leading US technology companies has added to investor unease. Worries over Europe and trade tensions have been exacerbated by economic data in China and the eurozone which have disappointed expectations. Against this background, the split Congress, which resulted from the US mid-terms, and has reduced the chances of further fiscal stimulus in the US, has been added to the list of worries for the market.
Time to lock in gains…?
This mood change raises the question of whether the bull market in equities, and risk assets more generally, now more than a decade old, is over. In particular, should investors now be locking in those gains and moving into cash or similarly safe assets?
We acknowledge that volatility has risen and prospective returns on risk assets are likely to be modest.
…not for us.
But we continue to expect equities to outperform both cash and bonds.
The fundamental reason for this view is that the backdrop in terms of economic growth, inflation, corporate profits and, yes, interest rates remains supportive. Growth is above trend in most major countries. With the exception of a few special cases in emerging markets, recession is absent. Inflation is also generally low, and the spectre of deflation has receded completely. US interest rates are rising and the Federal Reserve is shrinking its balance sheet. But interest rates remain low even in the US, and are ultra low in Europe and Japan. US growth is bound to slow next year both in terms of GDP and corporate profits. This year’s performance is simply unsustainable. But the slowdown will be to still-healthy growth rates. The area that seems most vulnerable to us is corporate credit, where we have been cautious for some time. We prefer to allocate our risk budget to equities, where we see better value.
But what of Brexit?
The situation here changes daily so any comments are offered with that caveat. One way or another, we expect the
Withdrawal Agreement to pass the House of Commons, perhaps at the second attempt. Uncertainty will remain as we move onto negotiations over the future trade agreement. But even if there is no deal, we expect some rapid moves to limit the associated disruption.
UK equities and sterling would rally on a successful deal and sell-off on a no-deal scenario, as expected. This uncertainty is sufficient for us to have been underweight the UK in a global context this year. Yet there is now sufficient negative sentiment priced into the market that we have moved back to a neutral position.
Back to normal
The volatility experienced so far this year stands in marked contrast to 2017, a year of almost unprecedented stability in market returns. But last year, not this year was abnormal. We must expect volatility to continue but, in our view, the bull market still has further to run.