The weakness experienced by stock markets yesterday is consistent with the 'bumpy journey' our CIO Anton Eser wrote about in his recent outlook, in which he anticipated that the removal of central bank largesse would stoke market volatility. Daily declines of 3% also feel less unusual in the context of my 20-year experience.
Fortunately it is not just my gut feeling that 3% moves have become more rare. A quick check of the past decade shows that over the last three years, the S&P 500 only fell 3% or more about once a year. In the seven years before that, those drawdowns occurred about five times per year.
It’s difficult to identify a convincing catalyst for yesterday’s selloff. A long list of potential culprits mentioned in the market include the surge in US Treasury yields (more on this later), a rotation out of tech stocks, the IMF growth forecast downgrades, US President Donald Trump attacking the Federal Reserve, risk parity funds needing to de-risk with a delay, a lack of corporate buybacks ahead of the earning season, and more companies complaining about a hit from the trade war, etc.
Something that does ring true is that the declines were at least helped by extremely bullish sentiment on US equities. While sentiment on equity markets overall was not overly stretched, in our view, sentiment indicators and surveys have been flagging unusual, US-specific optimism for a while, making US stocks increasingly at risk of smaller catalysts triggering a correction. Investor sentiment had been less bullish on other regions.
These are, in fact, also the reasons for our underweight US equity position. The fact that the selloff has been most severe in the US – despite the US market’s perceived safe haven status – is consistent with bullish US positioning having played a key role in it.
Several other developments increase our conviction on this point. First, the US dollar did not strengthen, which means we’re not seeing a dollar liquidity squeeze materialising. Second, emerging market (EM) assets held up relatively well, showing few signs of contagion. EM equities fared no worse than US stocks, EM debt performed okay and several under-pressure EM currencies were flat-to-stronger. Finally, and most encouraging in our view, Treasury yields fell amid the later part of the S&P decline. This suggests there is a self-correcting element to the selloff, if it was indeed driven by worries over rising yields.
Nevertheless, we would expect to start buying more equities around 5% below current levels (all else equal). Our 12-18 month fundamental view remains one of solid growth, low recession risk and transparent central banks: a generally supportive environment for equities. We have started to neutralise our short duration view – see Chris Jeffery's blog on the subject – and favour buying bonds at US Treasury 10-year yields of around 3.2%, which we consider roughly fair value. On top of that we are lifting some 'hedges' in the more unconstrained portfolios, which have done particularly well recently, to lock in some profits amid the market volatility.
We fully buy into the CIO’s view, that a backdrop of quantitative tightening and rising interest rates is challenging for a global economy with excessive debt and structurally declining productivity.
When debating the current market narrative with Ben Bennett, Head of Investment Strategy and Research, this morning, he said: "For me, it’s not surprising that a period of rising government bond yields has been followed by a sudden market correction. I think asset valuations have outstripped economic growth in recent years, but central bank support has more than offset underlying structural problems. As monetary policy tightens, I suspect the gap will narrow."
While we’d agree with much of the sentiment, the delayed reaction of the equity market gives an alternative interpretation for the past week’s market action. Equities rose during the period of yields rising and only started falling as bond yields stabilised/declined. This, in our view, suggests a continuation of higher bond yields being associated with stronger equities.
We’ve looked into whether yield moves have led equities historically and did not find a link – so in this instance, we’re inclined to take the same view, while recognising we can never be sure. One thing that gives us some support is that the sector pattern within equities was also not consistent with growing concerns over higher bond yields: the best performers in the US were utilities and real estate, the two most yield-sensitive sectors, as low beta and a lack of cyclicality seem to have dominated.
There's no doubt about it, though: equity-bond correlations will be very important for multi-asset funds, so it’s something we need to monitor closely. But for now we agree with Ben Bennett's conclusion in his February blog: "While government bond yields could continue upwards for now, we don’t believe this is the start of a trend where they move significantly higher."