By Wayne Yi, CFA
After a relaxing summer of benign markets and domestic equity indices setting new highs, volatility came back with a vengeance in October, and with less than a week left in the month, has taken away practically all the gains made so far this year. As of the time of this writing, the S&P 500 is down almost 9% on the month, taking the index negative year-to-date. It’s worth noting is that the leaders for the first three quarters of the year, Tech and Small Caps, are underperforming meaningfully so far in October, with the Nasdaq and Russell 2000 indices down 12% and 13.4%, respectively. The small cap index is now down over 3% on the year after peaking at 12% in August. The Nasdaq is clinging to small gains. The U.S. is not alone in this sell-off as International and Emerging Markets are also down over 8% this month and are deep into the red on a year-to-date basis at almost -10% on the EAFE and almost -16% in Emerging Markets. Additionally, the VIX is has touched 25 twice so far this month. In comparison, volatility had not broken 15 for the majority of the third quarter.
Volatility is back, but is below the first quarter spike
Source: Yahoo! Finance
We can clearly see investor rotation into a more defensive posture as Utilities, Consumer Staples and Real Estate are relative out-performers while cyclical sectors like Consumer Discretionary, Materials, and Tech are showing the largest declines in the month. In the -3% move of the S&P on October 24, these defensive sectors, which we’d argue are more rate sensitive, were the clear out-performers while all the other sectors were meaningfully weaker.
Source: Goldman Sachs Asset Management
Despite this sell-off in stocks, the domestic economy has remained resilient with above-trend GDP growth (>4% in 2Q18!), with historically low unemployment and inflation largely kept in check. While rising oil prices could put some upward cost pressures longer-term, the price of WTI has actually declined during the month of October.
The Leading Economic Indicators index is not yet showing any signs of deceleration and while we are still very early into earnings season, releases so far are supportive of continued growth with a large majority of companies thus far beating top- and bottom-line expectations and tracking towards a better than 20% year-over-year earnings growth. Forward guidance is the focal point this earnings season, and early announcements from semiconductor manufacturers Texas Instruments and AMD were soft and can weigh on growth-oriented names and cyclical sectors.We are monitoring these data points, but currently remain positive on broader corporate fundamentals, particularly in more value-oriented companies and sectors where we have more meaningful exposure.
Source: MQS Research, Bloomberg
As a result of the recent market correction, the S&P500 is now trading at under a 16x Forward P/E. While certainly not cheap, it is lower than where the index was trading over the summer when the markets were much more bullish.
While the balance of economic data has been positive, there are elements on the negative side that have caused some market consternation. The largest of these has been around the continued trade tensions with China with no real progress since earlier in the year. Negotiations will continue to drag on, and while China will likely be the larger sufferer in the interim, the U.S. will also experience some inflationary pressures and weakening demand as well. Headlines such as the “new” USMCA/NAFTA agreement are welcome news, but will have limited positive effect.
The Fed raised its target rate another 0.25% in late September, much to the chagrin of the President, but this has been well-communicated and anticipated by the market. While the 2-10 Treasury spread still remains relatively narrow, the 10-year note broke through 3% mid-September and touched 3.2% earlier this month. As investors can now earn a low, but real return on a risk-free asset, we expect some capital to rotate out of equities and into duration assets. We continue to avoid duration risk in our portfolios as our constructive view on the economy will likely push yields higher in the near-term.
Source: Financial Times, Bloomberg
Outside the U.S., geopolitical stress points continue to persist and have chipped away at global growth expectations, both in developed and emerging economies. In Europe, inability to establish a path for a smooth Brexit, coupled with questions around Theresa May’s ability to hold the government together, continue to weigh on the UK. On the continent, Italy hasn’t been able to propose an EU-supported budget, which is a bit nerve-wracking as it is one of the biggest debt issuers and the most levered, as a percentage of GDP, after Greece in the EU. Banking challenges in Germany and Eastern Europe have weighed on the region as well.
As a segue into emerging markets, the recent Khashoggi scandal has raised unexpected macro-economic concerns as a politically weakened Saudi Arabia is bleeding into Turkish and Iranian diplomacy and impacting oil supply and prices. This has exacerbated the headwinds to EM, along with the strengthening US Dollar, a slowing Chinese economy, as well as banking and monetary concerns in India, South Africa, Turkey, and Argentina to name a few, which has kept investors at bay.
The EM Currency Index has given back most of its gains this year, after a strong 2017
As we denote below, US GDP growth has accelerated into 2018, supported by the 2017 tax reform, bucking the trend of stable or declining growth elsewhere in the world.
Source: MQS Research, IMF
Furthermore, the IMF recently revised domestic growth up slightly for 2018 and 2019, while the majority of other countries were revised lower.
Source: BlackRock, IMF
However, we should be mindful that long-term growth expectations for emerging markets are still meaningfully higher than domestic markets and the Chinese government has plenty of tools and dry powder to spur their economy and drive liquidity into their markets in order to mitigate any significant economic slowdown.
International and emerging markets are trading with a relatively wider discount to the US than historically. While there is generally greater uncertainty in the resilience of the business cycles in other countries, current valuations are attractive and exposure to these markets should be a modest component of investor equity portfolios.
Source: MQS Research, Bloomberg
While we acknowledge that there is relatively greater risk to the equity bull market compared to the first half of the year, this recent correction seems to be over-done as fundamental economic momentum is still present. Thus, we still find equities to be the best asset class to drive portfolio returns at least for the next couple quarters. We detail the composition of this exposure further below, highlighting our bias for large cap value, which we think will better weather through increasing volatility.
Finally, the recent weakness was sudden, but is not out of the ordinary for equity market volatility. While the first quarter is a distant memory for some, there were two >7% corrections in that period, where if you sold in the downturn, you would have missed out on the ensuing double digit recovery through the end of the third quarter. We can’t predict how this spate of volatility will end up, but history has shown that long-term investors should not be taking off risk in these periods.
Outlook and recommendations
Source: MQS Research, Bloomberg
We continue to find the best risk/reward in equities versus other asset classes, but are closely watching the pace of growth across regions and progress on trade negotiations with China to refine our view. We are in the latter stages of the business cycle and recognize that earnings growth, not multiple expansion, will drive stock market performance and thus are closely watching third quarter earnings and guidance. While we remain overweight the asset class, we have been rotating towards a more defensive posture in Value and Large Cap and out of Small Caps and Growth stocks, which have been out performers this year. International and Emerging Market equities have suffered this year on the back of political uncertainty and trade tensions, exacerbated by the stronger US Dollar. Even with modest softness in growth, we find valuations attractive here and an allocation would serve as a diversifier to our domestic exposure. Inflation risk and further escalation of trade wars remain a concern.
Fixed Income: Underweight
Source: Wells Fargo Investment Institute
As the Fed continues on its steady hiking program, traditional fixed income offers limited return opportunities. We have shifted our exposure in the asset class to floating rate and idiosyncratic credit risk. We are leaning towards low-beta structural arbitrage opportunities to extract value, rather than stretching further down the risk spectrum. While the risk in high yield and levered loans are somewhat obvious, we are also concerned about the deteriorating credit quality of the corporate investment grade index as exhibited by the larger Triple-B composition and thus do not find value there either.
Credit Quality Composition of the Barclays Credit Index
Source: Barclays Capital
As rates rise, we are starting to see a path to value in fixed income, through municipal bonds, as an income generating, uncorrelated allocation to equities and are monitoring the opportunity closely.
Liquid Alternatives: Neutral
We remain selective in allocations to hedge funds and primarily view an allocation to the asset class as the “risk managed” component of multi-asset portfolios where clients can gain hedged exposure and generate short alpha during an increasingly volatile period in capital markets. Hedge funds are an alternative to fixed income exposure currently as they can offer better returns with lower correlation to rising rates and are an important component in reducing overall portfolio level risk for investors. Our areas of focus include structured and idiosyncratic credit, preferreds, and CEFs as low beta strategies with unique equity strategies as return drivers.
Illiquid Alternatives: Overweight
We continue to expand our roster of illiquid opportunities across traditional private equity, venture capital, middle market lending, real estate and distressed. We believe illiquids are less affected by turbulence that exists within public markets and will be able to generate significant alpha over time. We expect the illiquidity premium to generate 300-500bps of alpha per annum over public market equivalents for investors with a longer-term investment orientation.
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