- Rising interest rates triggered an equity sell-off last month, which was exacerbated by quant funds and corporate buyback blackouts.
- With the midterm elections behind us, we enter into a historically positive period for markets. What happens next might depend on the President’s meeting with China at the G20 summit later this month.
- While the fundamentals remain strong in the economy, we are beginning to see pockets of weakness that may signal an inflection point in 2019.
What Piqued Our Interest
October turned out to be a dismal month for risky assets, as the U.S. stock market realized its worst monthly performance since September 2011. After reaching a new all-time high on October 3rd, hawkish comments from the Fed prompted a treasury sell-off which drove interest rates higher as investors shunned stocks and bonds alike. As the bond yield “backup” accelerated, so did the pace of selling in the stock market. Just like the February correction, systematic selling pressure from high frequency traders and quant shops likely exacerbated the selling. An October 11 article in Reuters noted that there are an estimated $1.5 trillion in “mechanical” investment strategies, ranging from risk-parity funds, to trend followers and volatility-target funds. In addition, much of the selling was blamed on hedge funds unwinding crowded long positions, particularly in growth and momentum stocks which have long been in favor.
Another cause for the selloff came later in the month at the peak of the Q3 earnings season. While overall the third quarter has produced historically strong results, notable big-tech stocks were hit hard after failing to surpass investor’s expectations. Amazon reported lower than expected guidance heading into the holiday season, and in the same day Alphabet (Google) fell short on revenue projections. These “misses” sparked a broad sell-off across technology and discretionary stocks, guiding the broader market into correction territory (down 10% from peak) for the second time this year. The last time there were two stock market corrections in the same calendar year was 1950! Meanwhile, another factor which likely exacerbated the sell-off was the corporate blackout period whereas companies suspend buying their own stock during earnings season. As we approached the end of the month, resumption of buyback activity along with lower valuations provided a tailwind which helped lift stocks off their lows.
As the much-hyped midterm elections have now come and gone, unlike in 2016, the outcome fell in-line with expectations. As the Democrats now control the House, gridlock in Washington should result in little accomplishments, with the exception of a possible infrastructure spending bill. The markets have historically performed well during periods of divided government, and as we discussed last month, the six months following midterm elections in the past have generated the strongest returns of any 6-month period in the presidential cycle. All eyes now turn toward the upcoming meeting between President Trump and Chinese President Xi Jinping at the Group of 20 Summit in Argentina on November 30. Expectations for a trade deal are muted, however a temporary truce or ceasefire might be more likely, and if so, would certainly alleviate uncertainty and provide a boost to global equities which have been under pressure much of the year.
Outside of cash and short-term U.S. treasuries, there were not many places to escape the sell-off last month. The All-Cap U.S. equity index fell by 7.4%, with large caps falling 6.9% compared to 10.9% for small caps. For the year, U.S. stocks were either flat to slightly negative, although they have continued to rally in the early days of November (the S&P 500 was up 4.2% as of November 6). The worst performing sectors included Energy (-11.3%), Industrials (-10.8%), and Consumer Discretionary (-10%). The only positive sectors were defensive stalwarts such as Consumer Staples (+2%) and Utilities (+1.9%), both of which have underperformed during this strong growth market. The CBOE Volatility Index spiked from 12.05 on October 3 (which is an ultra-low reading) to 25.23 on October 24 and has since pulled back to around 20. From a technical standpoint, the S&P 500 traded well below its 200-day moving average, which usually serves as a support level during strong market periods. Since the market bottomed on October 29, the index is now trading back above the trendline and the market no longer appears to be in an “oversold” condition.
The results were generally the same for international markets, as the All-Country World ex-US index fell by 8.1% in October. Emerging markets fared worse than Developed, which is to be expected during periods of rising rates and heightened volatility. Europe declined less than Asia-Pacific (-7.6% vs. -9.6%), but both are still down double digits on the year. Concerns about Italy and Brexit have lingered on in Europe, while trade war fears have been the predominant negative factor in Asia. Fixed income offered little solace as the broad U.S. index fell 0.8% for the month, as high-yield credit fell by 1.6%. The yield on the 10-year treasury rose as high as 3.23% in October, from about 3.05% to start the month and 2.4% at the beginning of the year. Based upon the trend along with future Fed rate hike projections, it is likely that further highs will be coming in the months ahead.
AEPG Positioning and Outlook
For much of the past several years we have stated that strong fundamentals in the U.S. economy, including low unemployment, moderate inflation, and a pro-business administration, have warranted a bullish outlook on stocks and other growth investments. While the broad economic metrics remain robust, we are now beginning to see some signs of weakening that might mark a cyclical peak in the coming months. For example, average weekly hours in manufacturing has been on the decline the past few months. Also, weakness in the housing market has been surfacing, as new building permits have tapered off and home price growth has noticeably slowed. In addition, evidence of rising inflation is starting to manifest, which could escalate if the trade war with China continues into next year. Finally, we see signs that corporate earnings growth will probably peak this year, as the effects of the corporate tax reform are likely to wear off and employers are forced to increase wages to keep up with the tight job market. Given that the labor market is already below the natural unemployment rate at 3.7%, it is safe to assume that the clock is now ticking towards the next economic downturn.
It is probable that we will see new highs in the major U.S. equity indices, either this year or perhaps early next year. Retail expectations are high for the upcoming holiday season, global monetary policy remains accommodative, the labor market is exceptionally strong, and while rates and inflation are rising, both are still well below precarious levels. And based upon the market’s positive reaction after the midterm election, gridlock in Washington and the decreased uncertainty may also bolster stocks in the short run.
However, the growing list of concerns leads us to believe that the second half of 2019 may be a tumultuous time for the markets as we approach an inevitable recession which could occur in 2020 or sooner. Due to this outlook, our growth-oriented models at AEPG will likely continue to de-risk as we work our way through next year, rotating from growth to value stocks, and towards funds with factors such as high quality and low volatility. In fixed income, we expect to maintain our low-duration bias, but decrease our overweight to credit and increase exposure to safe treasuries and cash proxies. These model changes are of course data dependent, but like always we will err on the side of conservatism given the circumstances. There is little doubt that we are in the 4th quarter of this business cycle, and it is now time to begin preparing for what lies ahead.
A supplement to this month’s Investment Commentary is an article discussing our meetings with several Investment Strategists at this year’s Schwab Impact Conference. Please click on the following link to be directed to article on our website: https://aepg.com/its-not-about-good-or-bad-its-about-better-or-worse/