How we see things in global equities:
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The S&P 500 sell-off yesterday started with no specific trigger, but as we have been saying, many risks are looming on the horizon. However, the steep decline seen in the last hour was likely a combination of several market structure dynamics. As seen in February, the VIX spiked yesterday causing short volatility strategies to experience P/L losses; hedging activities late into the session likely switched to delta hedging, which takes place in the S&P 500 index futures and adds pressure.
Big changes in the VIX also trigger risk-management decisions (hedging equity exposure) in and of themselves, causing further selling pressure. Retail investors currently maintain their largest equity exposure in more than a decade, so some retail panic likely added to the selling pressure. Finally, there was a major rotation between value and momentum intraday with quant-driven funds likely offloading momentum stocks while buying value stocks; as momentum stocks (a large percentage of which are currently in the health care and technology sectors) have larger index weights, the net effect was negative on US equities.
As the chart at the bottom of this article shows, the expected real return on US equities is quite low at current valuation levels so we remain negative on US stocks for now.
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Italy is a time bomb, and represents a potential Lehman Brothers event for Europe should the new populist government go all the way against the European Union. For now, EU politicians are playing the game wisely by letting the market discipline Italy and hoping Rome comes to grasp with reality that it can ill afford its expansionary fiscal policy when it does not control its own currency. Keep in mind that French banks are heavily exposed to Italy, so there is contagion risk into core Europe in case the Italian situation spins out of control.
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The VIX curve is inverted and spot is around 24, which is a negative sign short-term for equities. If one fits a
Hidden Markov Model on the S&P 500 daily returns since the early 1990s (using 10 states), then the conclusion is that a VIX reading of 22 is where the market switches from being normal to negative (the states above VIX at 22 all exhibit negative return expectations).
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The US-China trade war seems to be escalating with neither side wanting to look weak. Our view is that no compromise will be struck before the New Year and thus the tariffs on the latest $200 billion of Chinese goods will go from 10% to 25% on January 1. This will worsen the economic environment as well as the outlook for corporate earnings.
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Risk parity funds are bleeding and yesterday showed another loss despite bonds being bid. As research circulated internally yesterday shows, we might be entering a new asset allocation regime where equities and interest rates are negatively correlated (like they were back in the 1970s and '80s). In this environment equities and bond will fluctuate together more often, making asset allocation more difficult. One could be cynical and say that asset allocation has been the easiest game over the past 25 years because of the covariance structure. Should we go back to older regimes, asset allocators will have to up their game to beat passive benchmarks.
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European earnings revisions are beginning to tilt towards the negative side. However, aggregate forward earnings estimates show analysts expect 8% earnings growth in Europe. That’s is simply too optimistic given the growth revisions from the International Monetary Fund earlier this week and Germany today. The economic environment will not offer the same tailwind as before.
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Interest rates are going higher, but the most important question is when we hit the inflection point where the market structure changes. At current interest rate levels we are seeing pain in emerging markets, and some real estate markets are also showing weakness both in Europe and the US. Federal Reserve chair Jerome Powell recently suggested that we are far from the neutral rate; if that’s the view and the Fed pushes on, we believe that it will likely make a policy mistake that triggers a financial market correction. Remember: pushing up the discount rate lowers the present value on future cash flows. So unless projected cash flows do not rise faster than the negative effect from the higher discount rate, financial assets will be marked down.
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Donald Trump is increasing his rhetoric against the Fed, calling the US central bank crazy and hinting that interest rates should not go further from here. This is the dark side of populists: they want to control everything, even the central banks (just think Hungary and Turkey).
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The short end of the yield curve is the only place to be safe if interest rates keep rising from here (read: one- to three-year government bonds). The good thing is that the investor can still get positive return in this segment under rising rates as long as the rise is controlled.
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We believe value stocks will stage a comeback against growth stocks as the higher discount rate impacts growth stocks more than value stocks. This is because growth stocks have a larger portion of their present value coming from cash flows way into the future. Using an analogy from the bonds space, you can view growth stocks as an instrument with a higher duration than value stocks so just as with bonds, as interest rates go higher, the assets with the highest durations are hit the most.
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We are not arguing gloom and doom just yet. In fairness, our Stronghold portfolios still hold a considerable amount of risky assets such as equities. Recent movements, however, do suggest that equity exposure should be lowered. Expected real rate returns are still higher for equities compared to bonds over the next 10 years, however, and this can be seen as adding some support. When the Chicago Fed National Activity Index goes negative together with US leading indicators, then the next crisis will emerge. Until then, what we will see is just a starter.
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The most depressing outlook surrounds the fact that at current valuation levels in US equities and US aggregate fixed income (government and credit), the expected annualised real rate returns over the next 10 years are 1.9% and 1.7% respectively. While still positive, the number is admittedly low. Assuming 2% inflation, the expected nominal returns will be 3.9% and 3.7% so for a standard 60/40 portfolio in the US, the expected annualized nominal return over the next 10 years is 3.8%. This is far from the long-term expectation of many family offices, endowment funds, and pension funds.
So could the sell-off continue? Given all the facts outlined above,
of course it could. Watch the VIX level: if it stays above 22, be negative, and if it dips below consider applying short-term mean reversion strategies/buying the dips.
Stay safe out there.
