Investment Outlook 11.2018
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Will the Fed spoil the party?
Equity markets fell peak-to-trough by about 10% between mid-September and the end of October. The trigger was hawkish comments by US Fed officials. As a result, US 10-year yields rose as high as 3.2%, which, in turn, worried equity investors. As a result, the sell-off of equities accelerated during October, further fueled by trade war concerns, the slowing of the Chinese economy, discussions around the Italian budget, and a more general late-cycle nervousness on the part of investors. At the same time, the traditional safe-haven assets hardly helped, since government bonds were down as well, albeit only marginally, and gold rose only 2% in October.
The big question for investors has been, “Are we in an equity market correction or in a bear market?”. During a correction, equities lose 10-20% and you typically like to hold on to your positions and potentially even buy into the weakness. During a bear market, when equities lose more than 20% you want to sell or reduce your position and wait for a re-entry at a later stage. Usually bear markets occur in the run-up to or during a recession. Since we see no indication of a looming recession, we rather think that what we experienced in October was a correction.
Major victims have been Japanese and emerging markets equities, which lost about 9%. For a change, US equities underperformed Europe, falling 6.9% in October compared to 5.9%. A notable exception from the sell-off of global markets was the Brazilian equity market. In the run-up to the second presidential election round on 26 October the Ibovespa rose about 10%. Market participants seem to have given the likely and actual winner of the elections, the far-right Jair Bolsonaro, a lot of credit for a positive economic reform program.
US yields rose by about 5 basis points in October, while European yields dropped about 10 basis points. Credit spreads widened across the board. Especially high-yield and emerging-markets bonds sold-off, albeit by much less than equities.
REITS proved their defensive nature and lost only 1.4%. Growth-sensitive commodities, energy and industrial metals fell significantly. Oil prices dropped almost 9% and industrial metals 5.5%.
The USD and the JPY gained in October. The USD appreciated 2.5% vis-à-vis the EUR and the JPY even rose 3.2%. The GBP benefited from expectations of a positive Brexit result.
In October most PMIs softened. The US ISM index fell to 57.7 after 59.8, and the EMU PMI fell to 52.0. The Chinese PMI, however, managed to rise slightly to 51.1 after 50.0. However, the China PMI remains very close to the critical level of 50. Levels below 50 indicate declining economic activity.
US non-farm payrolls rose strongly by 250,000 in October, which was above expectations. Average hourly earnings rose by 3.1% YoY, which is the strongest wage growth for many years. It seems that wage pressure is building, which could start pushing headline inflation up. However, US headline inflation for September (the figure for October is not yet available) fell to 2.3% after 2.7%. EMU inflation slightly rose in October to 2.2% after 2.1%.
On 7 October the People’s Bank of China (PBOC) announced that it would cut the reserve requirement ratio (RRR) for financial institutions by one percentage point, the fourth such move this year. This move frees up banks’ liquidity by an estimated USD 109 bn with the objective of expanding bank lending. This measure supposedly comes as a reaction to a slowing Chinese economy and as a measure to counter the negative impact of the trade war with the US. At the same time, the PBOC still regards its policy stance as neutral.
On 3 October Fed chairman Jerome Powell said that the Fed “… may go past neutral, but we are a long way from neutral at this point …”. These comments were taken as rather hawkish, sending US bond yields up and equity markets down. At its regular policy meeting on 8 November, the US Fed kept rates unchanged. The Fed said that economic activity has been rising at a vigorous rate and that job gains have been strong. Furthermore, chairman Powell repeated the outlook for further gradual rate increases. The Fed regards risks to its outlook as roughly balanced. It is widely expected that the Fed will raise rates for the fourth time this year at its 19 December meeting.
The ECB had its meeting on 25 October. It kept rates unchanged and did not change its policy stance or its outlook. The asset-purchase program will most likely end in December. The ECB will reinvest proceeds from maturing securities to keep favorable liquidity conditions thereafter.
On 1 November the Bank of England announced its intention to maintain the bank rate unchanged at 0.75% and to keep the stock of sterling bonds constant.
The Bank of Japan also kept its monetary policy unchanged at its 31 October meeting. The policy balance rate remains at -0.1% and the target for 10-year JGBs remains at about 0%.
There is no indication that the US economy will be slowing down significantly in the coming quarters. The impact of the trade war is much harder for China, other emerging markets and Europe, since the countries in those regions have a much larger import and/or expert sector than the US.
As wage pressure is starting to build, US inflation is likely to rise and the Fed will continue to raise rates. The next rate hike is expected for December. In our view, the market is still underestimating the probable future hiking path. Since real short-term interest rates are still negative, we regard the current Fed policy as still accommodative. There is a debate on where the neutral short-term interest rate actually is. It is safe to assume that the neutral rate is above 2.75, possibly above 3.0%.
On the back of stronger US growth and higher interest rates compared to Europe, we regard it as likely that the USD will strengthen further.
Rising rates and a stronger USD will tighten monetary conditions in the US, generating headwinds for US equity markets. However, strong evidence from past cycles suggests that this does not usually derail equity markets. On the other hand, equity-market corrections, as experienced in February and October, certainly become more likely.
As a result, we remain cautiously constructive on equities. Equities are likely to outperform bonds. We express this via a neutral or close-to-neutral equity position (small overweight of US equities) and a clear underweight of bonds. Despite recent credit spread widening, we remain underweight in credit. Overall, this results in a higher cash position, which we see as appropriate for reducing portfolio risks and which could be deployed into equity market weaknesses.