Created: Tuesday, 16 October 2018 14:31
Written by Goldman Sachs Asset Management
On October 10, global equity markets tumbled, led by the US, with the S&P 500 Index declining -3.3%. The VIX Index—a measure of US equity market volatility—spiked above 20 to its highest level in six months.
The event was US equity market centric, while the response in other assets and regions was relatively modest. This week’s equity market action follows an advance in global sovereign bond yields on several factors including moderating global growth, trade tensions and political uncertainties. Stock markets have since gained ground and perceived safe-haven asset demand has eased. Nonetheless, below we summarize ten key thoughts on the recent selloff, many of which discuss factors that extend beyond a single day’s move.
1. There was no single catalyst for this week’s equity market drawdown
With little fundamental news on the day, the equity market correction on October 10 was likely driven by several factors; a delayed response to a rise in global and in particular US real rates, hawkish rhetoric from US policymakers, concerns around global growth and trade being voiced in third-quarter earnings guidance and at the margin, due to selling from systematic trading strategies as assets breached technical resistance levels.
In our view, rate developments are the key driver behind downbeat sentiment toward equity markets this week, with nominal and real US 10-year Treasury yields exceeding 3.25% and 1%, respectively, reaching their highest levels since 2011. With respect to the nominal yield, the speed at which it reached this level has unnerved equity markets; the yield increased around 30bps between September 5 and October 5. For context, the yield has increased ~70bps so far this year. The steady grind higher earlier this year had been easily digested by equity markets. The rise in the real yield is particularly noteworthy as it reflects expectations for higher inflation ahead—something equities find difficult to digest. This repricing was induced by continued strength in US economic data and hawkish commentary from Federal Reserve officials, with Chair Jerome Powell noting that not only are we “far away” from the neutral policy rate, but we could also go beyond whatever the estimate of this rate is.
2. This week’s move was more orderly than what we saw in February
In February the VIX index experienced its largest one-day percentage change in its history. The spike higher this week was large but not of the same magnitude. That said, levered trading strategies were broadly neutral volatility in February but were short volatility ahead of this week’s move. This may help to explain why the S&P 500 Index experienced a three standard deviation move, while the VIX Index moved by seven standard deviations. Furthermore, the VIX curve has inverted, implying the near-term outlook for equities is considered to be more uncertain than the longer-term, though it is not as inverted as it was in February.
Trading volumes were one third of that observed in February, suggesting less panic selling, though investors were piqued by the magnitude of the VIX move relative to the S&P 500 Index. We are watchful of the potential for further VIX curve inversion and higher single-stock correlations, as this can encourage speculative activity in top performing equities.
3. The Great Rotation: US exceptionalism pause and value is outperforming growth
Continued US macro strength versus moderating growth in other economies has been mirrored in divergent asset class performance. Prior to the October 10 selloff, US equities had gained 8% this year, while global developed market stocks were up just 1% and EAFE equities (DM ex-US and Canada) were down -7%, while EM equities were -14% lower. The correction this week may see this US equity market exceptionalism pause; third quarter earnings releases will help determine if it resumes.
Within US equities, we have observed a rotation between growth and value stock performance, which has accelerated this quarter. This month, growth stocks are down -6%. Value stocks have also declined but less so, falling -2%. Growth stocks where positioning is crowded have experienced more pronounced moves, falling 10-15%, suggesting a recalibration of positioning. The outperformance of value stocks has been more pronounced outside of US markets. In fact, on October 10, European value equities saw their best one-day relative performance versus growth stocks since the global financial crisis.
4. Equity Valuations: US appears fair, EM undervalued
US stock valuations look reasonable given the strong growth and healthy earnings backdrop they are operating within. We forecast real GDP growth of 2.9% this year and low double digit annual earnings growth. However, we expect growth to moderate to 2.1% in 2019 and we think earnings momentum will slow as the boost from fiscal stimulus fades and price pressures mount. As such, we expect equity valuations to contract through to 2020.
EM valuations appear undervalued relative to their own history and relative to the US. Even after this week’s US price correction, the MSCI EM Index trades at its steepest discount to the S&P 500 Index since 2004.
5. Signs of US Equity market excess are rising but not yet concerning
To gauge signs of excess in the US equity market we look at demand and pricing in the initial public offering (IPO) market, as well as the post-IPO market response. Companies have been raising the price at which they will issue their stock to the market on multiple occasions, suggesting enthusiasm around the market environment, and yet stock prices have not appreciated materially once they trade in the secondary market. These dynamics point to excessive investor activity but encouragingly we have not yet observed a deterioration in the quality of companies going public.
6. Profit margin pressures are being ofset by pricing power muscle
US corporate earnings have been solid this year, though companies have been citing profit margin pressure arising from higher input and labor prices. That said, beyond secularly-challenged sectors such as Retail, companies in other sectors such as Industrials have been flexing pricing power muscle to offset these higher costs. We look ahead to third quarter earnings releases to ascertain whether a strong macro backdrop is allowing more companies to offset higher costs in this manner.
7. Macro fundamentals are cloudy, micro fundamentals reveal bright spots
Beyond the US, the macro backdrop has turned more nuanced due to moderating growth, trade tensions and political uncertainties. Growth in China has slowed and is set to slow further, though this is somewhat offset by policymaker support. European growth is reverting to a trend-like pace and faces political challenges stemming mainly from Italy, and commodity-importing EM economies face headwinds from higher oil prices. Firms exposed to macro developments have been impacted by these shifts. For example, Japanese robotics firms have seen orders from China slow meaningfully. Beyond the macro clouds there are micro bright spots,such as EM equity markets, where long-term growth potential is being unveiled by structural trends such a rise in e-commerce activity, increased healthcare spending and technological innovation.
8. Sector bellwethers to assess growth and trade: Luxury, autos and semiconductors
Within equity markets, we think the luxury goods and auto sectors are good bellwethers for gauging consumer discretionary spending, which can help to corroborate macro growth data and gauge the impact of the wave of protectionist measures introduced this year. This week a prominent luxury goods conglomerate reported tighter customs controls in China (though this may be linked to domestic policymaking that is independent of US-China trade tensions) and a global technology and automotive firm reported disappointing earnings that it attributed to lower demand, particularly from China. The semiconductor industry—the ‘raw material’ of a technology-fueled global economy—is another important sector to monitor. Annual growth in semi-conductor sales has moderated from 21% in March to 8% in August (source: Semiconductor Industry Association).
9. Fixed Income checkpoint: Higher DM rates, EMD stabilisation
The reaction in fixed income markets to this week’s equity selloff has been calm, with modest spread widening in US corporate credit markets. But as noted above, this may be due to rates having already moved higher earlier in the month. Within respect to US Treasury yields, the rise has been centered on a series of factors. These include continued strength in US economic data (the non-manufacturing ISM index reached a cycle high of 61.6 in September and the unemployment rate dropped to a 50-year low of 3.7%), discussions around a higher neutral policy rate (which implies there are more rate hikes in the pipeline before the Fed pauses), hawkish Fed commentary, and at the margin market dynamics such as selling from risk-parity funds.
Sovereign yields in several other developed markets have also tracked the rise in US rates; most of these moves are due to country-specific events. Constructive EU-UK negotiations and a new US-Canada-Mexico trade agreement has led markets to trade UK and Canadian rates on macro rather than political factors, which in both markets warrant higher yields. Meanwhile, Italian yields remain elevated around fiscal sustainability concerns.
EM asset performance has also improved after a weak summer due to helpful policymaker actions and diffused trade uncertainty. The JP Morgan EMBI Global Diversified Index returned 1.5% in September and spreads tightened 35bps to 335bps over US Treasuries.
10. Looking ahead: Higher volatility, but not a high volatility regime
This year is on track to register the highest frequency of three standard deviation moves in various markets since the global financial crisis. Episodes of higher volatility have been driven by several rather than a single factor; macro data surprises, policy changes, growth moderation and divergence, political uncertainties, trade tensions, higher oil prices and a withdrawal of global liquidity which, among risk assets, has disproportionately challenged emerging market assets. Overlaying this more nuanced fundamental backdrop is a change in market structures, with the advent of systematic trading strategies perceived to be accentuating the direction of any sharp market moves. We anticipated moderating growth and higher volatility in our 2018 Investment Outlook; however, growth is still expansionary and volatility can create investment opportunities and so we think it is premature for investors to de-risk.