As we have highlighted was likely through this year, the fourth quarter is proving to be the most difficult period in terms of achieving sustained positive asset returns globally. Having shown uncertain direction, but at least managing a start-stop recovery rally from the February correction until late September, global equity markets have again turned weaker in October and through November to date. Since peaking at 2,930 on 20 September, which (it must be remembered) was an all-time high, the US S&P 500 Index has fallen by a shade under 10% and effectively qualifies as being in a correction. Worst-affected in the US has been the Technology sector-heavy NASDAQ Index, which has fallen 15% since making a record high at the end of August. The main global share index, MSCI’s All Country World, has not actually recovered its January 2018 high and is down by 12% since then. While the New Zealand share index (NZSE50) has now dropped by 7% from its own record high logged on 21 September 21, it retains a small gain for the year to date of 3.8%. NZ shares have proven much more resilient to global weakness than their Australian counterparts. The ASX 200 Index is now down by 6.5% for 2018 to date and by almost 11% from its own September peak. Although NZ domestic equities have benefited from the comparatively defensive nature of many of our major listed companies and the benefits to exporters of a broadly lower NZ dollar, it would not surprise us if the New Zealand equity sector closed 2018 with very limited net gain, given its expensive valuation level.
Markets are clearly in transition mode, and we expect this to remain the overall mood until early next year. Throughout 2018, investors have been served a diet of increased uncertainty, resulting in directional swings and heightened geopolitical anxiety, not lessened by the perception that inflation may not be dead after its long, post-GFC hibernation. Because many global assets have experienced multi-year price gains justified by an absence of inflation pressure and the ample supply of funding liquidity (“easy money”) investors have become more apprehensive now that the US Federal Reserve is acting in a more conventional fashion and pressing on to modify potentially-troublesome late-cycle price dynamics.
Higher interest rates are evidently destabilizing equities. However, set against such forces are the still-upbeat news flows on US corporate profit growth (the highest since 2009) improved or stable employment levels, and last-minute compromises on trade policy, as occurred with the former NAFTA treaty in the Americas. Swings in the geopolitical risk roundabout have concerned investors, with disruption risk re-visiting the Middle East once again via Iran and Saudi Arabia, as well as concern on Europe rising due to the British Brexit struggles and the Italian Government’s budget difficulties.
Equities have remained volatile globally
Uneven surfaces ahead as policies confuse business leaders
Certainly, the higher US interest rate environment provides challenges for the future track of corporate earnings growth, as the decade of “easy money” and tax cuts to bolster profits gradually recedes. However, although the US President has focussed on blaming the Federal Reserve for equity market fragility, a comprehensive CNBC survey of global Chief Financial Officers (CFOs) released yesterday actually reveals other concerns ranking well above the interest rate outlook.
When asked to supply the largest risks to business, 35% of corporate CFOs replied that the greatest is US Trade Policy (i.e. tariffs and unilateral decisions,) while 24% cited Consumer Demand and only 14% nominated Central Bank interest rate policy as the critical risk. Fully 73% of the CFOs expect US Trade Policy to have a negative impact on their business over the next six months – increasing their costs while risking tit-for-tat restrictions on their export plans. Protectionism is beginning to hurt confidence in several important Northern Hemisphere economies, and this is flowing through to equity market performance in spite of very strong recent levels of profit growth.
We expect the final segment of 2018 to see a continuation of current volatility, as the risks outlined above add to tightening global monetary conditions as a challenge to equities. It is clear that the risks to the nine-year old bull market are clearly elevated. As we wrote in our most recent Quarterly Strategy Outlook the market weakness in early 2018, in our view, heralded a transition to a more fragile period for Growth assets and a turn in market sector leadership towards the defensive, higher quality and undervalued market sectors that have been left behind in recent years’ growth and momentum-driven rallies. Examples of the latter are the stellar returns from the globally-prominent US technology companies Facebook, Amazon, Apple, Netflix and Google, or the failure of Higher-risk Corporate bonds to reflect a deteriorating environment by means of higher yields, until quite recently.
The leadership of the US rally has been shifting, masked by patches of volatility and periodic relief rallies. Until mid-2018, the US market was being supported by upbeat assessments primarily for Growth stocks, notably the large Information Technology corporations like Facebook, Amazon, Apple, Netflix and Google (FAANG.) Needless to say, the valuation multiples of the IT sector have become stretched compared to the broader market. However, the post-August intensification of trade friction and Congressional activism have heralded a shift out of these companies’ stocks and a rotation into long-lagging Value segments. It would be too early to expect a full-blown sector rotation to get underway, though, as these historically occur when economic growth is slowing definitively and prospects for future corporate profit growth are fundamentally being called into question.
There is no US recession currently on the horizon, such as would be the usual accompaniment to a sustained period of negative equity returns. But, history also holds occasional examples of equity market slumps of 20% or more happening well ahead of an economic recession (for instance 1982, 1987, and 2000). We are not anticipating this order of decline, but are considerably more cautious given that valuations have not improved sufficiently, political risk has risen on many fronts, and fixed income securities have not displayed their traditional safe-haven features – which suggests interest rates could spook the markets more seriously if another spike upwards (e.g. through 3.5% in US 10 Year bonds) occurs.
We also remain most concerned at the trend for investors to move into Cash rather than Bonds at moments of market stress, which suggests a nervous market, and we allow for the more elevated risk that disappointments or shocks could generate a deeper correction. Full employment in the US, on the other hand, provides a near-term fillip to corporate income, as will President Trump’s deficit-funded military and infrastructure spending initiatives next year. A sharply lower Oil price, if sustained, will also cushion the negative shocks to business and consumer sentiment by lowering transportation costs.
Moderately-cautious portfolio positions still strongly favoured
We anticipate the difficult investment environment continuing, although, while global demand remains strong and interest rate rises remain well-telegraphed, more enduring difficulties may be postponed until 2019. All the same, market sentiment is febrile and in the climate of a less-than-unified US Government and less co-operative International institutions, the risk of a weak near-term period for returns is now the highest it has been for the last two years. We have resisted any impetus to “buy the dips” in equity markets this year, preferring to keep a decent Cash buffer in portfolios and a Neutral overall weighting to Growth asset classes. We will retain this until we are convinced that market turbulence is beginning to deliver value opportunities, at which point we are well positioned to redeploy our overweight Cash allocation and re-enter equity markets. This we would look to do, only if recessionary risks remain negligible for 2019. Otherwise, we would be more inclined to re-invest cash into the less-volatile and interest-rate sensitive Listed Real Asset sectors such as Property and Global Infrastructure. These assets have defensive features that we feel will continue to diversify portfolio risk better than the global fixed interest sector for the next year at least.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.