The recent US equity market setback seems to be little more than a wobble. The global economy is not in recession, although it is slowing down, and monetary policy is still accommodative across the board. Nevertheless, this is cold comfort to investors who have become sensitive to even smallish corrections.
Neither the US nor the global economy are close to recession: the Fed and other central banks are still accommodative, and financial conditions are still loose
Longer-term Treasury yields are not at levels that should force asset allocation changes out of equities and into bonds
Trade wars are painful, but they should not have a huge negative economic cost
Quantitative tightening and rising US rates are supporting the US dollar, but it has risen only 7% this year
Equity valuations are high, but shorter-term earnings growth is still strong
A bullish stance would be supported by US Treasury yields stabilising at current levels (around 3.15%)
A bearish view would see high-yield credit spreads start to widen from current levels
Global equities in general – and US equities specifically – have been tearing upwards for the past decade with few serious setbacks. Cushioned by the super-palliative combination of ultra-low interest rates and quantitative easing (QE), investors moved away en masse from sovereign and investment-grade bonds towards high-yield bonds and equities.
Yet recently, the global equity markets have experienced a series of stumbles that have unnerved investors a bit too much. Setbacks like these are arguably part of the normal process of markets – a way of clearing market excesses – but since the financial crisis, central banks have been loath to tolerate any loss of confidence in policy or in markets. Their supportive monetary policy has fostered a low-volatility, high-leverage, buy-the-dip mindset among investors, and a sense that central bankers have their backs. The upshot is a widespread sensitivity to even smallish corrections of 5% – such as the kind we’ve recently seen.
Admittedly, this jumpiness is mostly a US response; years ago, Europe endured its own euro-zone crisis while emerging markets were roiled with political and local issues. Nevertheless, the old adage still holds true: when the New York market sneezes, the world catches a cold.
Significant market corrections in US history
The brief list of equity market setbacks outlined in the accompanying table reveals a range of events, durations and magnitudes. It is also worth noting that the US fixed-income market hasn’t had a proper setback since the savings-and-loan crisis of the early 1990s, and the debt and loan carnage of 2008-2009.
As the same time, it is notable that nearly all of the triggers seen in the more substantial setbacks are in place today: fears abound over China, excessive fiscal stimulus, high oil prices, political uncertainty and overvaluations.
The long-running US bull market has been marked by multiple setbacks
Source: Bloomberg; AllianzGI Economics & Strategy. Data as at 15 October 2018.
So where are we now?
This year has been a challenging one for investors globally, with just one asset class – US equities – consistently doing well. In reality, however, growth in US equities has been almost entirely driven by the tech, consumer discretionary and health-care sectors; most other US sectors were down by between 5% and 25% as at mid-October.
The volatility shock of February unsettled investors around the world, yet a number of factors point to this recent bout of nerves as one that is "made in America”:
A hawkish Fed. The US Federal Reserve remains increasingly hawkish on its interest-rate projections, with the economy at full employment, significant fiscal stimulus at work and consumer inflation emerging.
Less liquidity. Accelerating quantitative tightening, combined with the new cash repatriation policy in the US, is beginning to impinge on global liquidity conditions for the US dollar. This, in turn, is placing pressure on weaker banking systems, overleveraged emerging-market borrowers and economies that are sensitive to high oil prices – including India and Indonesia.
Peak earnings. Today’s high earnings are matched by 2019 expectations for the US equity market, supported by President Donald Trump’s tax cuts. Yet this may in fact herald “peak earnings” for this cycle.
Peak buy-backs. Uncertainty is being fuelled by the quarterly cessation of US corporate share buy-backs. These will reach a record level in 2018, totalling nearly USD 1 trillion this year – 5% of US GDP – and nearly USD 5 trillion over the past five years. Buybacks on this scale have not been a factor in any other market.
Trade troubles. An increasingly aggressive US trade policy is also redrawing the globalisation consensus of old. The US is looking to corral China and its economic policy as it begins to acknowledge China as a strategic competitor in tech and intellectual property.
A late-cycle economy. We are late in what is already close to the longest economic cycle on record. The US economy may be burning bright thanks to President Trump’s fiscal stimulus, but it could come down to earth with a bump at some point in the next year or so.
All of these factors have been building for some time, affecting global investor sentiment while US investors have focused on the booming domestic situation. As such, it is possible that the latest market drop is simply the US catching up with global assets that already fell in 2018.
Where do we go from here?
It is worth remembering that the world is not in a recession, yet a host of factors point to a global economy that is going through some notable changes.
China is slowing as it rebalances, and it is hoping to avoid a trade war – hence its conciliatory responses to President Trump so far. If China doesn’t stay strong, Germany, Japan and others could see a slowdown in capital expenditures and investment, which is already coming under pressure from higher oil prices.
Inflation is beginning to brew globally as output gaps close and consumer prices rise. This will be exacerbated by tariffs and the challenging global weather conditions of this past summer, which affected harvests and are likely to drive food-price inflation.
During 2019, the European Central Bank will follow the path out of QE set by the Fed and the Bank of England, although this will be tempered by rates remaining super-stimulative.
Despite all these factors, politics and policy will have the biggest impact on international investor confidence; Brexit, Italy, India and the Middle East are all capable of providing shocks. And depending upon what happens in November’s US mid-term elections, investors will feel assuaged or need more clarity.
For now, however, this US equity market setback seems to be little more than a wobble. Europe and China are at or near critical support levels, as the accompanying table shows, but we have not yet reached levels that should cause major technical concern for US investors.
Overall, valuations will remain crucial to identifying attractive long-term returns. US equities do seem to be expensive, while Asian and European equities (politics notwithstanding) appear to offer better value, higher dividends and similar long-term growth prospects.
As we get later in the economic cycle, particularly in the US, we expect equity volatility to remain elevated; in this environment, we prefer an active approach, which can help identify winners and losers and provide an extra layer of risk mitigation for portfolios.
US stock indexes aren’t near critical support levels
Source: Bloomberg. Data as at 15 October 2018.
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Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.
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