October 22, 2018
Fears and side effects resulting from the recent equity pull-back, which brewed in the US before sending chills throughout other global indices, still linger. What caused the S&P 500 and Dow Jones to suddenly shed over 4%? What does it mean? Will it have a second coming? However, whilst it is human nature to seek a measured analysis of cause and effect post ante, it is also worth remembering that drawdowns are an inherent feature of functioning markets and do not necessarily portend something more gruesome like a recession. Since the current US bull market started in March 2009 we have seen approximately 26 pullbacks of 5% over the years, only 5 of which went on to become a correction of 10% or more.
In any case, commentators have rushed to give their diagnostics for the sell-off. One of the more plausible ones is that markets got spooked by the prospect of rising rates – but even still, this is something that has been foreseen for a while now. The sell-off ensued closely after the Fed hiked interest rates for the third time in 2018. Higher interest rates can result in tighter financial conditions, which could dampen future growth and it seems that equity markets might have reacted to that – just before the flight to safety caused the 10-year Treasury yield to hit a seven-year high of 3.25%. In reality, however, the rate hike itself was not a game changer for markets. The Fed has been transparent with regard to its intention to wean the economy from its monetary medicine, and whilst rising rates are real risk, they are not yet high enough to pose a threat (whilst growth and earnings remain at current levels). It is also prudent to note that since the 1960s, we have not seen a recession start without the effective federal funds rate being above 5%.
Another popular theory is that the US-China trade spat was weighing on margins, stoking fears that US firms may not be able to deliver sufficient results in the Q3 earnings season. However, it seems unlikely that this would have ignited such a broad sell-off given that no further shots had been fired by either side in the trade dispute. Already, strong Q3 results from some of the largest US companies have given the market a leg-up from the lows encountered after the sell-off, whilst analysts polled by FactSet expect third-quarter S&P 500 earnings to have grown by a solid 19%.
Others suggest that renminbi weakness and political drama in Italy acted as catalysts for the sell-off.
Whilst these ‘retrospective reasons’ are risks which we take seriously, what they all have in common is that none of them come as ‘new news’, altering the future outlook. Dissecting the anatomy of the sell-off to pinpoint the precise cause and effect may be somewhat comforting in that it paints a world of rules and rationality, but in fact sometimes, markets just correct.
When the market turns to panic, sticking to fundamentals prevents investors to get caught up in the emotion. We held our positions steady throughout the sell-off as we continue to believe in the favourable economic backdrop. GDP growth is robust, inflation is stable and there is still a lot of central bank induced liquidity. Further still, Q3 earnings season is upon us and profit margins in the US are touted to be slightly above 11% – the third highest in a decade! If this materialises, it would be painful to watch from the side lines.
To this end, what we want to stress is that a stock market move on its own should not reshape your view of the economy. The economy’s vital signs are much better measured by fundamentals – let these be the antidote to market panic.
Author: Group Investment Office