How much is your cash worth?
For answers about the global stock market dip of the past couple of weeks, we think you need to look at the bond market. That, mixed with some jumpy robots, is most likely the cause, we believe.
There’ve been a lot of trade threats – and action on them – over the past month. And then a massive storm ripped across the southern US. Hurricane Michael made landfall roughly at the same time American markets took a tumble. To top it off, China’s numbers have been getting steadily worse over past months. This leads some concerned investors to believe that global demand is about to fall significantly. If that were the case, markets would be in for a much greater fall than we have seen so far.
But, from what we see, it appears most likely that the sudden, sharp drops in global markets were triggered by a rise in US yields. On 3 October, US Federal Reserve Chair Jay Powell said interest rates, which were raised to 2.25% last month, were “a long way from neutral”. If US economic growth continued to be very strong, more interest rate hikes were likely. Almost immediately, US Treasury yields took flight; by 9 October the 10-year yield was 18 basis points higher at 3.25%. Short-term bond yields moved upwards too, but by a smaller amount.
Suddenly, the cost of capital – how much return shareholders and creditors demand for risking their cash – was significantly higher. The effect on stock markets was modest at first, but then accelerated last week as markets caught up: today’s value of all the cash you expect businesses to make in the future is much less if your cost of capital is higher. And if you factor in the worries about Chinese growth, general nervousness about trade and a tick down in US PMIs (surveys of businesses that tend to lead harder economic figures), perhaps there won’t be as much of those future earnings either. That would push values lower again. So you have a correction in markets, with the S&P 500 down 7%, the FTSE 100 down 7%, and the Shanghai CSI 300 down 9%.
Technology and companies that have done very well over the past couple of years were hit hardest. In a way, they’re victims of their own success. These ‘growth’ companies are the most liquid stocks, so easier to sell, but they tend to be on higher multiples of earnings and therefore their prices are more vulnerable to a rise in the cost of capital. Even though, from a business standpoint they actually have the low debt levels, stable earnings and high margins that allow them to take higher costs in their stride. Put another way, the companies that were hit hardest in the last couple of days are exactly the companies that will do best if a slowdown does actually eventuate. At least, in our view.
We know this is pretty cold comfort, as the last couple of weeks have been painful for many, ourselves included. ‘Value’ companies, typically those with higher leverage and whose fortunes are more anchored to those of the economy, have done better than growth in the recent downdraft. The S&P 500 Value Index is down about 5%; the S&P 500 Growth Index is down 8%. But zoom out a bit: year to date, growth companies are up almost 7%; value is down 3%. In the coming months economic growth may slow, companies may lower earnings guidance; but the economy could be perfectly fine and shrug off the rise in yields. Either way, we think quality companies – those with low debt and strong cash flows that are less reliant on greater economic growth – are the best bet for the future.
What made this sell-off so jarring could be that bonds and equities posted simultaneous falls. Portfolio management 101 says that when equities fall, safe haven bonds tend to gain in price. That negative correlation broke down in the past couple of weeks – as we said at the beginning that’s because the fall in bond prices sparked the fall in equities. But it’s unnerving.
We think bonds will continue to be a good balance to portfolios in the long term, but short term we could be in for more bouts of simultaneous falls if the pace of US monetary tightening carries on unchanged and economic growth starts to tail off.
Source: FE Analytics, data sterling total return to 12 October
Political distractions
As we roll into another round of company reporting investors will be less concerned about the 19%-odd annual increase in S&P 500 earnings – or even the FTSE 100’s 7.5% earnings expansion. Instead they will be focused on outlook statements and alterations to guidance on future profits. Just how much effect increased trade tariffs will have on commerce over the coming year is the question everyone is trying to answer.
President Donald Trump may talk with his Chinese counterpart, Xi Jinping, about trade policy at the G-20 meeting in Argentina next month. Many analysts and economists hold out hope that the two global giants will soon come to an agreement over trade. If not, there’s a chance that the tit-for-tat tariffs will curtail already relatively weak worldwide growth and increase the chances of a recession.
Domestic politics are bad enough for flighty investors without spilling over into any more cross-border problems. As the US heads into the midterms, the divisions of its society and politicians is quite possibly the widest since the Civil War. The Republicans and the Democrats are pulling in polar opposite directions, making business decisions hard to make. If you’re a business-owner, do you invest now if you think one party would rip up everything the other’s put in place if they took power?
Similarly, Brexit leaves an even greater bifurcation for the UK’s possible futures. The British government and the EU weave from an imminent compromise deal to turning motorways into lorry parks for the border chaos that will accompany a no-deal Brexit.
It takes a really poor political climate to make people disappointed with 20% earnings growth. But here we are.
Bonds
UK 10-Year yield @ 1.63%
US 10-Year yield @ 3.16%
Germany 10-Year yield @ 0.50%
Italy 10-Year yield @ 3.57%
Spain 10-Year yield @ 1.67%
Economic data and companies reporting for week commencing 15 October
Monday 15 October
US: Monthly Budget Statement, Empire Manufacturing, Advance Retail Sales, Business Inventories
Tuesday 16 October
UK: Claimant Count Rate, Unemployment Rate, Average Weekly Earnings
US: Industrial Production, Capacity Utilisation, Manufacturing Production, NAHB Housing Market Index, JOLTS Job Openings Treasury International Capital Flows
EU: Trade Balance; GER: ZEW Survey
Final results: Bellway, Nanoco Group
Interim results: Footasylum
Trading update: Merlin Entertainments
Wednesday 17 October
UK: Inflation, House Price Index, BoE's Financial Policy Committee Minutes
US: Housing Starts, Building Permits, Federal Reserve Meeting Minutes
EU: New Car Registrations, Construction Output, Inflation
Final results: ASOS, Softcat
Trading update: Barratt Developments, Rathbones Group, Segro
Thursday 18 October
UK: Retail Sales
US: Philadelphia Fed Business Outlook, Initial Jobless Claims, Continuing Claims, Leading Index
EU: GER: Wholesale Price Index
Quarterly results: Domino’s Pizza Group, Unilever
Trading update: International Personal Finance, Renishaw, Rentokil Initial, RWS Holdings
Friday 19 October
UK: Public Sector Net Borrowing and Net Cash Requirement
US: Existing Home Sales
EU: Current Account
Quarterly results: Acacia Mining, London Stock Exchange Group, Provident Financial, Schlumberger
Trading update: Dechra Pharmaceuticals, Essentra, Record