For the past few days we have seen equity markets across the globe go through a bout of selling pressure. Spanning both developed and emerging markets, equities have been led by the US markets and are down anywhere from 5–8% over the last few days. Similar to late January / early February this year, it has caught a few investors by surprise and no doubt been the cause of the odd skipped heartbeat.
Bad day overdue
Over the ten years since the bankruptcy of Lehman Brothers, we have all become accustomed to extraordinarily low volatility in markets. In addition, we’ve become accustomed to one direction lately, and that’s up. As I mentioned in February, pullbacks in markets are (usually) quite normal and healthy, giving moments of pause where everyone pats themselves over, does a quick sense check and then carries on.
The drawdown from the peak in the US equity market is currently sitting at about 5%. So far, that’s well within the realms of what should be considered ‘normal’. We remain vigilant to anything that might change the fundamental outlook, especially when considering the removal of monetary policy accommodation. But we are not rushing to make changes to portfolios just yet.
What is behind the sell-off?
As we pointed out in our previous blog, the fundamentals of company and consumer actions don’t change overnight.
There is usually a lot of finger pointing at times like these. Some market commentators point to rising bond yields, citing the 10-year US Treasury or government bond having risen through 3.2% (a level last seen seven years ago in 2011). Some point to the ongoing US-China trade dispute and the impact protectionist tariffs in the US are having on businesses and the consumer.
Others cite companies being less optimistic about the future than Wall Street analysts. Meanwhile there are those who point to passive investment vehicles and computer algorithms being the root cause of the problem. While the accusations mount, skittish investors take money off the table, exacerbating the fall in markets.
If no one seems to agree on what the problem is, it probably means we need to look through that noise to see what the underlying fundamentals are telling us.
Rising bond yields
Bond yields in the US are rising for a combination of factors, including the removal of extraordinary monetary policy by the Federal Reserve and the European Central Bank; tentatively rising inflation pressures and a glut of Treasury issuance by the US Treasury. Theory tells us that the effect of rising yields is to adjust the risk attitude of the market, sending equities down in the short term. However, the evidence from data going back to 1962 shows that when yields are rising, 75% of the time equity markets are also rising.
There is certainly a good chance that trade wars are causing uncertainty for businesses and for the markets. However, this is not new news. It is true that Mike Pompeo, the US Secretary of State, received less than a warm embrace on his most recent visit to China. But what did people expect? The US has been slapping tariffs on China since the start of the year and has disengaged from negotiations. Chinese officials stated the obvious – they aren’t going to entertain negotiations on China’s trade and business practices until the US ceases escalating tensions through ever higher tariffs.
Not a huge amount has changed with the business outlook. The benefits of tax cuts in the US are giving businesses a big boost while the US consumer is showing continued signs of confidence.
Computer-powered investment strategies
By some accounts, over 60% of daily trading volume in the US equity market is driven by algorithms of one description or another, be they for high frequency trades or on behalf of passive investment vehicles re-balancing their portfolios. Several market commentators have noted trading activity undertaken by these vehicles is concentrated into narrows windows at certain times during the day, which can lead to exacerbated moves.
We are also just entering the quarterly reporting season for US companies, which is a good test of what’s happening on the ground and will give us a better view of market fundamentals than watching what jittery trigger fingers are doing.
Welcome back volatility
Increased volatility is a healthy sign of investors becoming more conscious of the risks inherent in markets. The voices through our investment team are all saying “steady, hold, wait a moment”. Attempts to time market trends are fraught with difficulty even at the best of times. They require two successful decisions: when to get out, then when to get back in. The latter is always the most difficult and can lead to a big reduction in returns if markets bounce back sharply while you are still holding cash. When markets are moving around violently these decisions become even more time critical. So our strategy is not to try and be too clever in trying to take advantage of these situations, other than to invest a little for portfolios holding higher levels of cash.
Kasim Zafar, Portfolio Manager