ANALYSIS OF THE STOCKMARKET CORRECTION

Transcription

1 ANALYSIS OF THE STOCKMARKET CORRECTION For investment professional use only

2 The US equity markets nosedived on Wednesday last week, dragging Asian and European markets down in their wake. The S&P shed 3.3% that day, while on Thursday the Nikkei then lost 3.9%, the Euro Stoxx fell 1.8% and the CAC 40 was down 1.9%. Tech stocks were the hardest hit, with the Nasdaq plummeting 4.1% on Wednesday, its largest decline since it went tumbling on news that the UK had voted to leave the European Union on June 24, US indices again took a severe beating on Thursday, with the S&P shedding 2.1%, while the Nasdaq lost 1.3%, but Asian markets recovered and European indices limited their losses on Friday. Despite a slight surge on Friday, the S&P ended the week down 4.1% overall, while the Euro Stoxx 50 slid 4.5%, the CAC % and the Nikkei 4.6%. WHAT TRIGGERED THE PLUNGE ON THE EQUITY MARKETS? The sharp surge in US bond rates provided the catalyst for this move. The 10-year rate had moved slightly above the 3% mark in mid-september, then surged sharply on October 3 and 4 to hit a high unseen since May 2011, seven years ago, to close at 3.23% on October 4, having traded in a range between 3.05% and 3.1% since September 18. Ostrum ANALYSIS OF THE STOCKMARKET CORRECTION - 2

3 These bond yields dampened investor interest for the US equity markets in three ways: firstly, by raising the cost of borrowing for companies, secondly by denting the present value of future earnings, and thirdly by making equity markets comparatively less attractive when compared to the fixed income markets. Persistently low interest rates over recent years have made the bond markets fairly unattractive, as investors focused more on the equity markets and their higher returns, sending the stockmarkets soaring. However, this perception changed when US bond rates climbed to a 7-year high, triggering a massive sell-off on the equity markets on Wednesday and Thursday last week. Two other factors also hampered the stockmarkets: Oil prices soared to reach a 4-year high on October 4, with WTI hitting $76.4/bbl and Brent $85.8/bbl. Declining production in Venezuela along with US sanctions on Iran triggered fears of inadequate supply, while oilproducing countries (OPEC and Russia) seem in no hurry to offset this shortfall. Rising oil prices dent corporate margins and lead to a deterioration in purchasing power for households, thereby hurting sales. Lastly, the market dip was triggered by increasing investor concerns on the risk of a trade war between the US and its trade partners first and foremost China. This was one of the factors behind the IMF s downgrade to world growth to 3.7% in 2018 and 2019 vs. 3.9% expected back in April, and projections from the various institutions so far show that all countries will be affected, with the US poised to take the greatest hit. ARE RISING BOND YIELDS THE RESULT OF FEARS OF HIGHER INFLATION? This is clearly not the case, and inflation projections as priced in by the markets have stabilized at a reasonable level since the start of the year. 5-year inflation, as measured by inflation breakeven, stands at around 2.2%, which is well below the 2013 figure, while consumers inflation expectations measured by the University of Michigan remain at their lowest point since So inflation expectations remain steady, and this can be attributed to the Fed s credibility, as the central bank has gradually been hiking key rates since December 2015 to support the recovery in growth and progressively reduce its accommodative monetary policy slant. On September 26, it hiked its key rate for the eighth time since the end of 2015 (third time since the start of this year), bringing the Fed funds range to [2%- 2.25%] vs. [0%-0.25%] between December 2008 and December It also started cutting back the size of its balance sheet from October 2017 by gradually reducing the amount it reinvests when securities mature. In other words, monetary policy is steadily normalizing to get back to neutral, at least initially. Are investors expectations on US growth changing? Yes the Trump administration s expansionary fiscal policy is changing the situation. US growth took a clear upturn in the second quarter, displaying a 4.2% jump on an annualized basis, and figures are set to remain buoyant in the third quarter if we rely on currently available stats. Massive household and corporate tax cuts are fuelling domestic demand and hence growth. What are the consequences of this expansionary fiscal policy for the Fed? This highly expansionary fiscal policy comes at the end of the economic cycle i.e. in the 10 th consecutive year of growth and against a backdrop of full employment as jobless numbers hit their lowest since 1969 in September this year (3.7%). The Fed has no other choice but to march on with its rate hike cycle to keep a lid on growth by tightening monetary policy if it is to successfully avoid imbalances that would drive up inflation. Fed chair Jay Powell was very clear in this respect during his press conference on September 26: the Fed is poised to continue its rate hike cycle to offset the effects of the Trump administration s policy. Projections from the various Fed members show that they expect a fresh hike in December, followed by three more in 2019 (unchanged since the June minutes) and another in Ostrum ANALYSIS OF THE STOCKMARKET CORRECTION - 3

4 The markets hadn t fully factored in this rate hike outlook, which explains why bond yields rose. Has the Fed gone crazy as Donald Trump claims? No, stronger moves to hike rates were required to make up for the White House s fiscal policy going off track, and also to maintain the Fed s credibility on price stability. If it does not change its policy to adjust to this situation, inflationary pressure will appear and this would be much more damaging for growth and the financial markets. Are bond yields set to surge sharply? No, for two reasons: firstly due to the ongoing limited inflation projections as a result of the Fed's monetary policy; secondly, as the acceleration in growth has turned out to be temporary. Fiscal policy should continue to have a relatively high impact in 2019, but it will start to ease. Trump s measures do not point to more robust growth for the longer run, but protectionist moves could cut back corporate investment and drag down companies output and hence long-term growth. Incidentally, this also reflects the total inconsistency of the administration s policies. Potential growth is more moderate than before the crisis or 30 years ago due to weaker output growth as well as the ageing population, so these factors curb the scope for long rates to go higher. THESE FACTORS TRIGGERED A SELL-OFF ON THE STOCKMARKETS Rising US rates along with more pervasive fears of a trade war and escalating oil prices triggered a sell-off by investors on the US equity markets, after the gains notched up since February turned out to be unsustainable. The effects of this trend also spread to other world markets. Tech stocks had previously buoyed US indices, but in last week s sell-off they were most affected due to their high valuations i.e. Amazon, Apple, Facebook, Netflix, etc. Some of them were even harder hit due to their high exposure to trade wrangling between the US and China i.e. semi-conductors and electronic chip companies that are particularly affected by the increase in border tariffs due to their high degree of integration into the world production chain. The market slide was made even worse by the fact that some companies were not able to buy their own shares due to black-out periods, i.e. the period leading up to their earnings reports when they are not authorized to buy their own stocks. Yet these share purchases provide strong support for the US market. The decline on the US stockmarkets therefore seems to be a correction after an unsustainable surge, as was the case in late January-early February Once again rising US bond rates had been behind this trend, against a backdrop of trade war concerns with the threat of border duties on steel and aluminum and rising oil prices. So the equity markets should swiftly recover, buoyed by renewed company share buybacks. However, volatility is here to stay due to current risks hanging over world growth i.e. trade tension with China, continued high oil prices, risks on Italy and Brexit, and some weakness among emerging markets with high external deficits and hefty dollar-denominated debt. Against this backdrop, the Fed will need to skilfully steer its communication to prime the markets for forthcoming monetary policy tightening and keep tension on the bond markets to a minimum. Ostrum ANALYSIS OF THE STOCKMARKET CORRECTION - 4

5 ADDITIONAL NOTES Ostrum Asset Management Asset management company regulated by AMF under n GP Limited company with a share capital of euros Trade register n Paris VAT: FR Registered Office: 43, avenue Pierre Mendès-France, Paris This document is intended for professional clients in accordance with MIFID. It may not be used for any purpose other than that for which it was conceived and may not be copied, distributed or communicated to third parties, in part or in whole, without the prior written authorization of Ostrum Asset Management. None of the information contained in this document should be interpreted as having any contractual value. This document is produced purely for the purposes of providing indicative information. This document consists of a presentation created and prepared by Ostrum Asset Management based on sources it considers to be reliable. Ostrum Asset Management reserves the right to modify the information presented in this document at any time without notice, and in particular anything relating to the description of the investment process, which under no circumstances constitutes a commitment from Ostrum Asset Management. Ostrum Asset Management will not be held responsible for any decision taken or not taken on the basis of the information contained in this document, nor in the use that a third party might make of the information. Figures mentioned refer to previous years. Past performance does not guarantee future results. Any reference to a ranking, a rating or an award provides no guarantee for future performance and is not constant over time. Reference to a ranking and/or an award does not indicate the future performance of the UCITS/AIF or the fund manager. Under Ostrum Asset Management s social responsibility policy, and in accordance with the treaties signed by the French government, the funds directly managed by Ostrum Asset Management do not invest in any company that manufactures, sells or stocks antipersonnel mines and cluster bombs. Ostrum ANALYSIS OF THE STOCKMARKET CORRECTION - 5

6 Ostrum Asset Management Asset management company regulated by AMF under n GP Limited company with a share capital of euros Trade register n Paris VAT: FR Registered Office: 43, avenue Pierre Mendès-France, Paris Ostrum ANALYSIS OF THE STOCKMARKET CORRECTION - 6