November 2018 - Navigating Through Rough Waters
Updated: Nov 21, 2018
After a steady rally in the prior few months, October marked a significant downturn for equity markets and a sharp increase in volatility. The MSCI All-Country World Index dropped -7.6%, the steepest monthly decline since May 2012 and the VIX index climbed 75%. The main drivers behind the sharp declines were (1) fears that earnings and margins in the U.S. have peaked (2) concerns about global growth (3) fears of a Fed policy mistake (4) geopolitical risks and (5) weak market technicals. We think the sharp declines are rather natural for this stage of the bull market and have presented some opportunities but volatility is likely here to stay. Although we don't necessarily expect a major correction in the coming months, we advocate selectively reducing our overall equity exposure in favour of cash and going up the quality spectrum in bonds in order to reduce portfolio volatility and wait for more opportunities.
Although many U.S. companies delivered solid earnings in Q3 (42% have beaten expectations), the key takeaway from this earnings seasons has been lower guidance for next year and rising cost pressures. Worker wages have been edging higher given the tight labour market (average hourly earnings hit 3.1% YoY) and tariffs on Chinese products could lead to higher input prices. While most growth indicators in the U.S. remain solid and ahead of the rest of the world, the risk of a normalization of earnings growth next year and stretched valuations will keep volatility high in our view. We therefore prefer to modestly reduce our overweight allocation in U.S. equities. In European equity markets, stocks remain exposed to the continent's decelerating growth prospects (Q3 GDP came in at 0.6% SAAR), trade war exposures and high political uncertainty. Nonetheless, we think equities are fully pricing in many of the risks with half of the Stoxx 600 companies in bear market territory. Company fundamentals have been improving throughout the year and overall P/E ratios now look attractive compared to their own history and vs. the US. We therefore see the risk/reward as more appealing at the moment and increase our allocation to European equities. Elsewhere, we reduce our exposure in Japanese equities a bit given the prospects of a stronger Yen and slow earnings growth. We also modestly increase our allocation to EM equities given attractive valuations and prospects of a weaker dollar following the midterm elections. The risk is an escalation in trade wars and Chinese slowdown.
Weakness in equity markets spread into credit markets, with spreads wider across the USD and EUR corporate markets. US Investment Grade (IG) and US High Yield (HY) markets saw spreads widen 12 and 53 bps respectively, delivering total returns of -1.4% and -1.6% respectively. European markets fared worse, with EU IG wider by +14 bps and EU HY wider by +58 bps. Leveraged loans continue to outperform and delivered flat returns in October. Given the prospects of further spread volatility, we prefer to be invested in higher rated companies with little downgrade risk. US IG should outperform on a beta-adjusted basis given that supply volumes are likely to be low and yield-sensitive investors may be attracted by current levels (4.4%).Within the HY space, USD HY offers a yield of 6.8% (spread of 368 bps), while EUR HY is yielding 3.8% (spread of 400 bps). We think European HY will outperform US HY on a spread basis, but this is conditional on Italian government bonds stabilizing and positive news on Brexit.
In Emerging Markets, currencies continued to depreciate vs. the USD (-1.1% on average in October and -11.6% YTD), led by the Mexican Peso which depreciated 8% on the back of the vote to cancel construction of the Mexico City Airport. Encouragingly, the two weakest and most volatile EM currencies this year (Turkish Lira and Argentine Peso) appear to have stabilized and strengthened in recent weeks. Weaker currencies and the risk-off sentiment continued to put pressure on external debt spreads which widened 21 bps in October (+61 bps YTD). Going forward, we think that EM debt valuations are attractive, particularly against US high yield, but country and credit selection is very important.
The key drivers for risky assets going forward will be whether the trade war between the U.S. and China escalates or not, the outcome of Brexit negotiations, and whether the Fed continues its normal hiking cycle as expected. There is a chance that the US could reach an agreement with China during the G20 meetings at the end of November, though this is not our base case. We think trade war uncertainty may persist for a while, but the market will rally on any signs of progress. With regards to the Fed, there is a disconnect between the Federal Open Market Committee projections and the market (the latter is pricing in 2 more hikes by the end of 2019 vs. 3 hikes by the Fed). If the Fed adjusts its forecasts lower, the dollar should depreciate and risky assets should rally.
Overall, the market is dealing with a large number of risks that will leave investors on edge and keep volatility high. Although equity markets have stabilized in recent days, we prefer to gradually sell rallies to prepare for the next downturn, and going up the credit spectrum in bonds. A further selloff could present another buying opportunity as we don't expect a recession in the next 1-2 years. As always, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance.