Autopsy of a stock market sell-off

15 October 2018

Last week, we wondered why stock markets had not reacted more negatively to the latest upward wave of bond yields, when this had led to a formidable stock market correction back in February. As it turned out over the course of this week, it seems to have just haven taken them a little longer to come to terms with the fact that, whether it’s higher inflation expectations or better than expected growth that’s pushing bond yields higher, the outcome is the same: higher bond yields that choke equity market upside prospects.

By the end of this week, the stock market sell-off has become more pronounced, with equity markets around the world having lost around 6% since their September highs. We’re not quite yet in correction territory (-10%), but the fact that, compared to February, this has pushed them in many cases below their 200-day moving average does not bode well for investor sentiment in the shorter term. Experience tells us that once certain critical threshold levels have been broken it is much less likely for markets to resume their previous upward (or at least sideward) trend.

Most commentators remained somewhat baffled that this time it had been positively surprising US economic data that appeared to have caused the trend reversal. Consequentially, the search for other culprits was in full swing all week. Slowing demand from China, Trump’s path towards an exploding US budget deficit – which makes even Italy look fiscally responsible – as well as the looming trade wars with China were all put forward as reasons why the 2018 US equity market rally had suddenly hit the buffers.

Unfortunately, as is usually the case, the stock market downdraft is highly contagious and so stock markets around the world were caught in the spiral. Given the other industrialised regions around the world are still operating far earlier in the economic cycle with still far lower rates of interest, bond yields and equity valuations, the $1million question is whether this sell-off will herald a change in market leadership away from the US, where growth may still be strong but also turning over.

We are obviously not happy that investment returns have turned negative but having anticipated and positioned portfolios for this very development to happen since the spring, we are not entirely dissatisfied that our view has panned out.

So, what next? Well, market slumps like this one tend to unfold in waves and we will not be surprised to experience a sharp relief recovery wave next week, as it already started late on Friday in the US market. Given the general economic and sentiment environment is not dissimilar to the February correction, this one may well follow a similar pattern: the relief rally petering out, another swing down, before more positive investor sentiment prevails. That is, unless the economic environment should have deteriorated in the meantime.

With the Q3 2018 corporate earnings season having kicked off on Friday and US banks broadly beating already high expectations, we can expect positive economic news flow to provide a soothing effect.

Amongst the obvious negatives, this equity market setback also has a few positives. Firstly, it has stopped the upwards draft of bond yields which should mean that, just as before, the economy and capital markets have time to assess and adjust the impact of gradually normalising bond yields. This slower unwind of overvalued bonds from the past decade lowers the risk of a ‘bond market riot’, where bond holders collectively head for the exit and cause a cycle-ending capital market shock to the economy.

Secondly, US president Trump has claimed the positive US stock market as one of his personal achievements. This suggests that, the longer and deeper the current ructions last, the higher the incentive for him to strike a deal with China before the November Midterm elections in order to regain the stock market tailwind.

Over in the ‘old world’, Italy’s populist government continues to annoy the Brusselites with defiance of their austerity dictate. Given the sums involved, we don’t expect much lasting damage, even if the resultant hike in Italian bond yields defeats the very point of looser fiscal policy. However, the rest of the EURO area benefits from the squabbles by holding down the value of the €-EUR, which helps to divert some of the US growth momentum across to Europe.

The opposite was the case for the UK this week, where £-sterling rose to its highest levels against the US$ and €-EUR on the back of persistent rumours of a wider Brexit negotiation breakthrough. Together with an extension of transition periods and invoking of the Northern Ireland backstop (which would keep the whole UK in customs union with the EU until a more sustainable framework for future trade relations have been defined), turned markets more positive.

This is all very much what we have suggested to happen over the past weeks. And while capital markets and the business community may be sighing in relief, the political side should become quite hairy under such circumstances. It’s not entirely inconceivable that the terms of the initial Brexit will have to be passed by the parliament with a cross party majority of the moderate middle rather than being sabotaged by the minority extremists on both sides of the spectrum. It would be refreshing to see a temporary cross-party consensus of the pragmatists for the good of the nation prevail over those happy to sacrifice the common good in order to achieve their ideological ideals.