Volatility spikes – patience is paramount

Chief Investment Officer's team, 15.10.2018

Global equity markets, led by the US, sold off aggressively last week, reminding us of the “flash crash” episode of last February. Volatility should never come as a surprise in 2018 (and beyond) as the investment backdrop combines late cycle features (elevated valuations and rising rates) with multiple political uncertainties, exacerbated by the very energetic leadership style of Mr Trump.

As it was the case in February, bond markets led and caused the risk-off episode, with a sharp rise in the 10Y UST yield the week before, backed by strong US data. As some companies additionally warned on the impact of trade tariffs on their margins, investors questioned the sustainability of the current earnings growth, as they could be hurt by a combination of higher funding costs, wages, and expensive tariffs. The correction was brutal on equity indices, triggering the unwinding of positions from some hedge funds (which were long relative to their own standards), some risk-parity funds (who cut an asset when its volatility spikes) and finally the hedging of some derivatives and structured products (even if this time we didn’t see the collapse of short-VIX ETF as we saw in February).

Global equities lost 3.8% during the week, with Emerging Markets at -2% outperforming Developed Markets (-4.1%). Within DM the performance expressed in USD was homogeneous between the US, Europe and Japan. Sector-wise, Industrials, Materials and Tech were the worst performers while Utilities, Telecoms and Staples played their defensive role.

Our stance is the following. So far, critical technical levels have held, but we have no guarantee that the episode is over, especially as we are only three weeks away from the crucial US Mid Term elections. The current earnings season will certainly not be of great help as concerns are on the future earnings and guidance rather than on Q3. In essence, the short-term is as always highly uncertain, and the current episode could get worse (February was worse). For the medium term, however, there are three good news. First, rates are rising for the best possible reason, i.e. because the US economy is strong, which in fine supports earnings. Second, equity P/E multiples are now more attractive as they lost around 2 points across the world, and it supports the medium-term potential for returns. Third and finally, the US Dollar has not rallied, and Emerging Markets have been slightly more resilient during this episode, which provides comfort to our positive view for the end of the year. This risk-off episode might not be over in the short-term, but we believe it will not be more structural than the February sell-off.

Fixed income update: long UST 10Y and EM debt

The breakout in the 10-year Treasury yields towards the 3.25% has weighed on risk assets and caused worries for the broader financial markets. That’s the signal from measures of volatility embedded in options on interest-rate swaps. While both three-month and one-year options on 10-year interest-rate swaps show a sharp pick-up in the pace of fluctuations, their levels aren’t close to peaks reached earlier this year. Treasury yields move closely in line with similar-maturity swap rates. That said, real yields in the US are now above 1 percent and at the highest since 2011, which makes them attractive to investors. We maintain our overweight positioning on the US Treasuries and expect to see a further flattening of the yield curve going forward. The pace of the upward shift in nominal yields YTD is almost 85bps which could be seen as overdone given the macro backdrop (moderating growth, global trade tensions) and the need for risk-free returns from the broader investor community. The Fed hiking in December is in our view already priced-in by markets. Last week’s benign inflation report further confirms our view on price pressures. CPI headline increased 0.1% in September, below consensus expectations for a 0.2% rise. This pushed down the year-on-year rate of change to 2.3% from 2.7%. Some deceleration was expected, as consensus projected a 2.4% print due to base effects, stronger CPI readings in the second half of 2017 implied some moderation in the year-over-year comparisons. Moreover, FED’s preferred gauge, the core PCE deflator, should likely hover around the 2% in the coming months and should not have material adjustments to our expectations on the path for further hikes and the implications to the current valuations on the Treasury yields.

Within Emerging Markets, some notable gains led by Turkey, Brazil and Argentina on back of recent developments on the trade pact by the US, Mexico and Canada, and the release of US Pastor Andrew Brunson helped investor sentiment. Turkish ten-year hard-currency Sovereign bonds strengthened and rallied 36bp to yield at 7.53 percent while the Turkish Lira closed at 5.87 against the US dollar extending some support for the domestic bonds. India’s consumer price inflation registered another downward surprise at 3.8%, remaining below the Reserve Bank of India’s medium term target of 4.0%. RBI’s unexpected pause to keep policy rate on hold at 6.50% earlier this month should also support bond prices in the near to mid-term. We maintain our positive stance towards the asset class.

The United Arab Emirates passed a long-anticipated law that would allow its federal government to issue Sovereign bonds. The Ministry of Finance highlighted that it would establish a Public Debt Management Office to oversee the new federal-level borrowings. As new debt gets issued at the federal level, it should trigger yield convergence for the outstanding bonds and Sukuks issued by other Emirates. The Dubai Sovereign bonds which are not rated have always traded wider to the rest of the emirates, including Sharjah and Ras-Al Khaimah. The establishment of a UAE yield curve has been long awaited and should support liquidity and provide better funding conditions for governments and corporations going forward.

Equity update: we hold our positions

A US stock market sell-off, with the S&P 500 ending last week 4.1% lower, was mirrored by other developed markets. Emerging markets equities lost 2% in USD, with China the worst contributor (-3.6% for MSCI China in USD) but India (+1.4%) and LatAm (+1%) positive. The US was hit by a combination of rapidly rising US Treasury yields, continued trade tensions, and concerns about earnings and margins. The VIX index rose to a level of 28 but was nowhere near the February level of 50. Trading volumes in the US were at one-third of February levels indicating that markets were not panicking. Friday saw markets recover somewhat, however, we are not calling for a short-term bottom in a backdrop made of China-US confrontation and imminent mid-term elections.

Investors have begun fearing that rising interest rates and government bond yields, could start affecting corporate profits and global growth. Trade tariffs too are feared to have the potential to add to inflation and the cost of goods. 10 Years Treasury yields at 3.2% were inevitable with the current Fed policy, so why the sharp reaction by the US stock market last week? It’s more to do with US-China tensions over trade tariffs, intellectual property theft, threats to the US technology sector and cyber hacking. Higher rates generally reflect an improving economy for the longer term and tend to boost stock prices. That has generally held true over the last 30 years, and more recently in the post-crisis period.

Last week’s headlines focused on the tech sector as it has the largest weight in indices, but the selloff was broad-based. and all 11 global sectors saw a decline led by industrials and materials. The more defensive sectors i.e. telecom and utilities which have been the worst performers so far in 2018 and have a low weight in global indices, fell the least. Value as a factor had a slight lead over growth but not significant. Going forward this is showing signs of shifting and we could see a rotation into the sectors with lower valuations such as banking and energy especially in the US, where valuations are becoming a focus, as doubts emerge on the sustainability of strong growth.

Equity performance and market cap growth have been aided by the introduction of new industries in the technology sector, which have grown exponentially and accounted for a significant share of the stock market gain. Whille the technology sector still leads returns globally, +8.1% year to date, it has given up 4% of its gains in just one week. Hedge funds lightened positions on the favored group of big U.S. tech names, the FAANGs. The semiconductors sector up 40% in 2017, led the rout in technology stocks as guidance and earning updates indicate slowing demand, which reflects on the industries that use the chips. Annual growth in semiconductor sales has moderated from 21% in March to 8% in August. The sector was one of the biggest losers and -8% quarter to date, though still flat for the year. Large chip users have also begun setting up their facilities to reduce dependence on suppliers. We have been advocating booking partial profits since the beginning of the year on the technology winners. Our conviction remains firm on the continuing growth of cloud services, robotics and data analytics, AI in industrial use, healthcare and financial services.

For most of 2018, the overweight stance on tech and growth stocks has served investors well. Even with the recent pullback, Amazon shares are up 53% this year, Netflix 77% and Apple 31%. The key risk is that these beautiful stories are also popular, widely held, and sometimes part of leveraged or derivatives-based strategies which can trigger brutal position unwinding.

The fundamentals of the US market remain unchanged; in fact the first half 2018 earnings growth of 25% has brought US valuations to reasonable levels at 15.8X the next 12 months expected earnings. It looks like US companies will achieve the 20% earnings growth expected by consensus in Q3. JPMorgan Chase, Citigroup and Wells Fargo have kicked off the Q3 earnings season with above consensus numbers, on account of growth in income from consumer lending and spending. This was a positive surprise as rising interest rates make it more expensive for households to borrow. Default rates too improved in the third quarter, indicating improving disposable income. Despite higher debt loads, U.S. consumers, (excluding mortgages), owe a record $4tn in the form of student loans, auto loans and credit cards, but are paying out just under 10% of their disposable income on interest payments, according to Federal Reserve data. That is down from over 13% in the run-up to the financial crisis.

Will US equity market divergence with emerging markets, which trade below median price to earnings multiples continue? The MSCI EM Index at 10.2X 2019E Price to earnings is at its steepest discount to the S&P 500 Index since 2004. Emerging Markets are undervalued relative to their long-term average (median since 2006 is 11.5X Price to Earnings) and to the US. Earnings momentum will slow down for the US as the boost from the tax cuts fades, and input costs for companies increase along with wage growth. Inflation we feel however will be controlled with the efficiencies of technology. However, while US corporate earnings growth will slow, it is still expected to reach 10% in 2019 by the consensus. We thus hold our US positions. Some of the best quality names, companies with sustainable growth and a high spend on innovation backed by strong cash flow companies are based in the US. We also see potential in some unloved sectors including US financials as rates rise and the energy sector with growing payouts. Emerging markets offer a compelling value trade with growth double that of the developed markets, and we would gradually and selectively invest, even though geopolitical and trade tariff concerns may require patience.

GCC markets performance was in line with global markets. The Saudi Index was the worst performer at -5.8% last week wiping out the year’s gains. Geopolitical concerns are adding to Saudi market woes. The UAE indices weathered the world contagion better: the Abu Dhabi Index fell the least at -0.8% along with the Dubai Index which also fell only 1.3% last week. The latter has seen some steep declines led by the real estate sector, however the Index at 7X 2019E Price to Earnings leave little danger of further pullbacks. Oil prices are supportive of GCC equity market performance, however, the breadth of the markets limits the interest of international investors. As more companies list in the region especially in the consumer and healthcare sector, the market will offer a more diversified offering.

Cross-asset considerations: time for gold?

In the past week 10-year US real rates consolidated above the psychologically important 1% mark, after breaching it decisively for the first time in the last seven years. Being one of the primary drivers of the ebb and flow of global liquidity, investors are now wondering whether world economies are in for a tightening of financial conditions, as rates may have further to go. Furthermore, at a level of 1.5%, with nominal rates at 3.5% assuming US inflation at 2%, long-dated Treasuries would start to look compelling versus equities on a risk-adjusted basis.

Before jumping the gun, one should first pragmatically consider that historically, during Fed tightening cycles, US 10-year Treasury yields have tended to peak in line with shorter-term rates. The Fed officials’ forecast for Fed funds is at most 3.3% in 2020, hence, if history is anything to go by US 10-year yields should at most be at that level at the end of the cycle.

This is relevant news for gold prices, sensitive to the direction of long-dated yields. Capped US real rates mean gold can be ripe for a bottom and find more favorable conditions in 2019, versus the crushing ‘America First’ performance of US assets this year. On Friday gold forcefully broke above 1,200, amidst generalized risk-off market sentiment. The emphasis here is on ‘generalized’, as gold needs risk-reduction across the board to perform as a safe haven asset, something akin to what we witnessed last week, when both DM and EM equities dropped simultaneously, the first time since the February sell-off.

US real rates play a pivotal role for EM hard-currency bonds as well. Lately, EM USD bonds have rebounded with rising US rates, so there could be some residual weakness in store for the asset class shorter term. On a longer-term basis, though, money would start again flowing into EM bonds as their yield becomes increasingly appealing against that of Treasuries.

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