The most dangerous saying in markets and finance is “this time it is different”.
As we endure the second major correction in equities this year, the performance of yields on US Treasury bonds suggests something has changed. Instead of falling sharply when equities swoon, yields in January and February at best went sideways and resumed climbing. We are now seeing a similar pattern as the S&P 500 index has endured a very rough October. Yes, the 10-year yield has eased back from its peak of 3.25 per cent, but at around 3.10 per cent it remains above where it was when the S&P 500 closed at a record high in September.
Not so long ago, early in 2016 when equities suffered a big drop, the 10-year Treasury yield behaved in a far more helpful manner for risk assets as seen below. Portfolios hit by losses in their equity holdings were offset by a rally in Treasury prices that pushed yields lower.
Clearly the relationship has shifted. The big picture view is that higher yields as equities stumble reflect a bond market driven more by a Federal Reserve steadily trimming its balance sheet, while the US Treasury is selling more debt to finance a gaping hole in the federal budget — as we see with three-month T-bills at 2.33 per cent today, a new decade high.
Also at work is the stance of the Fed; it has signalled further policy tightening and under Jay Powell appears to be far less willing to back off whenever equities encounter turbulence. This is a key change since the taper tantrum of 2013 and one that I suspect equity investors fail to appreciate.
We are much later in the economic cycle as illustrated by a tightening jobs market and that means the Fed is looking to eventually slow things down and keep inflation contained, rather than worry as they did in previous years about short circuiting a recovery via tighter financial conditions. Thanks to tax cuts and a fiscal shot in the arm for the US economy, monetary policy is back in the business of normalising.
The quantitative easing era of rising equity and Treasury prices is over and as Bill O’Donnell at Citi in New York told me today:
“You can’t avoid the pain and get all the pleasure. Stock and bond prices went up for several years and why can’t they go down together.”
So where does this leave equity markets?
Europe has been flagging a slowing China and data out today showed that growth in the eurozone economy eased to an annual pace of 1.7 per cent during the third quarter after a revised 2.2 expansion for the previous three months. Weaker growth in China, fear of trade war escalation and the issues of Brexit and Italy’s budget tussle with the EU have long weighed on equity sentiment before Wall Street started catching up lately.
These are challenges and worrisome, but at this juncture not enough to end the current cycle argues George Lagarias, chief economist at Mazars:
“As long as central bank hawkishness doesn’t manifestly slow the global economy (which it hasn’t), trade wars don’t stoke inflation (which they haven’t) and European politics don’t destroy the euro (still there), investors are right to tread carefully, but it’s probably premature to feel afraid.”
David Bianco at DWS also notes the “S&P usually gains 15 per cent-plus in six months after a correction without recession”.
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While the recent drop in equity valuations should tempt buyers of the dip, there has been little reward for companies delivering solid earnings.
Courtesy of BlackRock the blue line represents the performance of the MSCI World index and the green line shows 12-month forward earnings-per-share estimates for the index (both series are rebased to 100 at the start of 2017):
While the asset manager notes that expectations of robust global growth over the next year with moderate inflation is a favourable backdrop for earnings, they add “the range of potential outcomes for corporate earnings looks to be widening, just as uncertainty around the growth outlook has risen. The outlook for corporate margins could turn south if trade conflicts escalate in 2019 and pricing pressures build further, potentially hitting earnings.”
When we look at the performance of the S&P 500 this month, weakness has been broad based, suggesting worries about the global economy are coming home to roost for large US companies. Energy, consumer discretionary (skewed in part by Amazon being a big member of this group), industrials and materials are major S&P 500 sectors that have outpaced this month’s drop seen in technology.
This shows how higher Treasury yields are finally hurting equities, argues Capital Economics:
“We have long been of the view that the stock market would take monetary tightening and higher Treasury yields in its stride while the economy continued to fare well. We have, however, consistently argued that monetary tightening would take a toll on activity next year, and that when this became apparent the stock market would fall, as it did before and during the last two economic downturns.”
Junk bonds feel the heat — The two big exchange traded funds that track US high yield corporate bonds, JNK and HYG, have both dropped to their lowest price since November 2016. As oil and gas comprises some 10 per cent of each ETF, this month’s pressure on energy shares is rippling through to the debt market.
Dollar divergence — Against major rivals, the dollar is flirting with its best level since June 2017. While the euro and yen lose steam, emerging market currencies are enjoying a respite. With the offshore renminbi touching Rmb6.97 to the dollar earlier today, the fireworks just need a match.
Amazon and the Faangs — The NYSE Fang+ index is down some 20 per cent from its peak with heavyweight Amazon having dropped a quarter from its all-time high, with its tenure as a member of the $1tn market-cap club a fleeting moment that leaves Apple all alone.
Russ Mould, AJ Bell investment director, says:
“There is an old market rule which says that when the individual stocks or sectors that took the broader market indices higher start to tire and roll over then everyone needs to be careful. The ongoing slide in the share prices of the Faangs in the US and Baidu, Alibaba and Tencent (the Bats) in China must therefore be followed closely. If this proves to be no more than a so-called ‘healthy correction’ then all well and good but if these stocks really do start to fall to earth, weighed down by regulatory pressure, growth concerns or simply their enormous valuations, this could have serious implications for investors’ portfolios.”
Trade war escalation watch — As Donald Trumps ups the ante over trade, and threatens to place tariffs on all goods exported by China, there are consequences for equities.
As Citi explains, until now, US tariffs implemented on Chinese products “focused mainly on goods that are easy to substitute. However, tariffs on the remaining $267bn goods, mostly consumer goods, will have a larger inflationary impact.”
The bank warns:
“Amid tight labour markets and higher input costs, we think there is a risk that firms decide to pass through some of the costs to consumers.”
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