Australian Market Strategist, Saxo Bank Group
Summary: The factors behind the recent weakness in equities are structural and profound, and volatility could pick up further as we head into 2019.
On October 3, Federal Reserve chair Jerome Powell jinxed stocks when he stated that we remain “a long way” from neutral; the market then essentially flipped from record complacency to panic. The sharp rise in US 10-year yields to a seven-year high above 3.2% at the start of the month caused market participants to sharply reconsider asset prices as Treasury rates are the foundation for valuation across all asset classes.
October progressed against a backdrop of rising rates, rising political risk into the US midterm elections, trade war, European issues relating to Brexit and the Italian budget, and the US earnings season highlighting a peak in corporate profit growth and margin expansion. The simultaneous unwind in positioning has been violent given positioning before the sell-off. In such a situation of crowded positioning, once momentum rolls over, the floor essentially drops with everyone running for the exit at the same time.
The sudden rise in real yields drove the rate increase, not inflation expectations. This is important as rising real yields calls valuations into question. As the discount rate rises, this acts like gravity on growth stocks, a segment typically heavily weighted towards technology stocks. On the ASX 200, though, the healthcare sector also falls into this cohort of high-growth/high-PE stocks deriving their present value from future cashflows.
High-growth stocks are hit hardest as their lofty valuations arise from the prospect of high future earnings. As the discount rate rises, this erodes the value of such shares because the present value of high earning streams is worth less once discounted. The Nasdaq is on course for its worst month since 2008 as these dynamics play out in real time. The negative sentiment and discount rate dynamic has flowed through into the ASX with the Australian tech sector, taking its lead from Wall Street, being the worst performer throughout the month of October. Tech was closely followed by healthcare, another victim to the reversal of growth/high PE positioning.
As oil prices increased and Brent crude hit highs of $86/barrel in early October, the risk of demand destruction rose as well, particularly within the emerging economies that account for a large proportion of demand growth for oil. For example, in India, given the strong USD and rupee depreciation year-to-date, the price of oil in local currency terms has risen to levels not seen since 2014 when oil was trading above $100. Throw in Saudi Arabia’s pledge to produce as much as possible and Opec’s concerns about oversupply and we have seen a dramatic turnaround from the $100/b oil forecasts seen not so long ago.
Higher bond yields also start to call into question positioning in equity markets and asset allocation more broadly as risk premium rises and yields approach levels that start to compete with dividend yields, meaning that risk reward becomes less attractive for equities in general. For a conservative investor, the yield on a two-year note or one-year bill for a conservative investor is getting to levels where it can compete with stocks’ dividend yields, bringing about a seismic shift in asset allocation that only adds pressure to equity markets. The ‘buy the dip’ strategy that has worked all year is now much riskier.
Investors will be rewarded for positioning cautiously against this backdrop and overweighting defensive sectors within equities. In terms of factor exposure, we see sentiment tilting towards low beta/minimum volatility, quality, and value (which can be played through ETFs and by reducing exposure to high PE, momentum, and high beta positioning). The VIX is still above 22, which is statistically a short-term negative for equity markets.
The silver lining is that we could see another push higher for equity markets before year-end, but any rally will be shorter lived than its predecessors. Following a final push, equity markets will succumb to ever-increasing headwinds and significantly lower earnings growth next year. We are approaching a seasonally strong period for financial markets; going back to 1930, the average November-December price change for the S&P 500 in midterm election years is 3.5% (according to Bloomberg data). We also note that the buyback blackout period is ending, and global growth, while decelerating, is not actually contracting. Global equities are pricing in the worst-case economic outcome heading into a seasonally strong period, which could lead to some positivity into the end of the year.
Fast forward into 2019, though, and US equities look dangerous. We will have slowing repatriation of funds and fewer buybacks (which have artificially suppressed US equity volatility and buoyed the stock market), peak profit margins as the fiscal stimulus fades, and rising input costs rising due to energy, wages, and tariffs. 2019 has the potential to be a tumultuous year for all asset classes with maximum Fed tightening, draining dollar liquidity, and rising interest rates. Volatility will likely increase in intensity as the Fed moves further into a financially restrictive phase throughout 2019.
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