Mark Whitehead gives his explanation on the recent bout of market volatility and what it means for global equity income funds.
After a prolonged period of very benign market conditions, we are seeing a bout of volatility and a sharp move lower in most markets from their peak on 26 January.
For some time, we have been referencing the fact that synchronised global growth has been improving, combined with an explosive period of positive earnings estimates revisions. This has come against a backdrop of central bank policies which, on the whole, have continued to remain very accommodative. Adding fuel to the fire at the end of 2017, President Trump’s reform of corporate and personal taxes also gave a boost to expected activity and company profitability. This has all allowed equity markets to move to excessive valuations, particularly in the US. Indeed, January set many records, with six new highs in the first six days of trading in 2018 for the S&P 500.
Since October, the first signs of inflation ticking up prompted many commentators to speculate that the withdrawal of liquidity and monetary policy tightening might be implemented sooner than had previously been expected. Bond yields responded with a move higher and this has accelerated in January, the US 10-year Treasury yield jumping from 2.41% at the start of the year to 2.85% at its peak on 2 February.
This brought about a growing fear of a disorderly bond market sell-off and contagion into equity markets causing volatility to pick up from benign levels as the selling increased. Why? Higher bond yields translate into a higher price of risk used to value all other asset classes and ultimately an increase in the cost of doing business. The reasons for the recent falls in equity markets have been attributed to systematic trading algorithms used in Exchange Traded Funds (ETFs) triggering extreme selling pressure as levels of liquidity shrank.
When the really heavy selling started on Monday 5 February, no sector or style in the US won out, with the exception of utilities and REITs which have been excessively lagging the market for a very long time. All other sectors were down pretty much in lockstep. This could be to do with the ETF selling pressure we have seen where liquidity has been at a premium so the very largest most liquid stocks have been used as a source of funding by traders.
We saw something a bit like this in 2008, but ETFs, quant and smart beta funds have become more ubiquitous since then and this, I think, is why we saw some very sharp falls in US markets in the last hour of trading yesterday.
Risks & Opportunities
The risk is for contagion worsening from here. Selling has so far been centered around retail investors and we are yet to see large institutional long-only equity holders really step into add to the selling pressure. To us, not much has changed. Global economies are strong and bond yields are higher with an equity market that looks cheaper than six to eight days ago. In fact, the move lower in markets, could be viewed as a necessary correction. These days the corrections seem to happen ever quicker (a matter of days) but I am sure Black Monday 1987 where the Dow Jones Industrial Average fell 508 points (22.61%) felt much worse...!
We expect markets to stabilise shortly and opportunities will arise for those that have missed decent returns over the past few months to buy cheaper growth stocks. We will certainly look carefully for any opportunities. We are not sure whether the recent prolonged regime of expensive high momentum growth stocks leading market returns will be derailed, as investors may not change their behaviours and look for other alternatives too easily (why change a winning formula especially if it is now cheaper?).
We feel sure that this period of volatility at the closing stages of a record bull market will not be the last, but we are not entering a sustained market reversal just yet.
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