Share markets fell sharply in October, led lower by the technology-heavy NASDAQ index in the US. Many major market indices are now in negative territory for the calendar year.
A notable feature of market behaviour through October was that bond markets also came under downward pressure. Diversifying into bonds turned out to be a less effective tool in mitigating volatility than it has been over the past five years. Defensive diversified funds with a large commitment to bond markets experienced a disproportionately large increase in realised volatility.
In this article I seek to provide an explanation for the downturn and address the outlook for share markets. The key points are:
- The fall in equity markets appears to have been triggered by a sharp rise in US bond yields;
- It’s a feature of share markets these days that when they fall they fall sharply;while the rise in bond yields was driven by growing confidence that US economic activity is likely to remain robust, it did lead investors to worry about the consequences of higher interest rates;
- There don’t appear to be any major imbalances in the US economy so there is low risk of a recession in the year ahead;
- Despite rising uncertainty, expectations for corporate cash flow and dividends appear largely unchanged; and
- So, the medium-term return expected from share markets is now a little higher compared to five weeks ago.
Was October’s sharp decline in share markets expected?
Short-term movements in the share market are virtually impossible to predict.
Nonetheless, the factors that appear to have contributed to October’s market decline have been the subject of debate and commentary throughout the year. These factors include:
- Tightening of monetary policy in the US due to the progressive reduction in the size of the Federal Reserve’s balance sheet and the ongoing rise in cash rates;
- Valuation multiples in many major markets trading above average;
- Appreciation of the US dollar and the cost of borrowing US dollars, due in part to the changes to US corporate tax rules, negatively impacting both emerging markets and Australia;
- Expectations that central banks in Europe and Japan will begin to tighten monetary policy
- Rising trade tensions between the US and China that could depress economic activity and push up production costs; and
- Rising input costs due to labour market tightness.
For some reason, in October, investors collectively decided to become a lot more concerned about these risks.
We have observed, across the year, strains emerging in various parts of the capital markets. In February, there was a blow-up in the market for financial insurance. In the second quarter, emerging markets performed poorly while the Chinese share market exhibited profound weakness in the third quarter.
In that sense, large capitalisation technology stocks in the US were the last major sector of the market that had been untouched by a sudden evaporation of investor confidence. That changed in October.
Has the decline in share markets been unusually large?
Corrections of the order of 10 per cent in share markets are a normal feature of these markets – including when they are in a long-term upward trend. However, it’s the abruptness of the decline that took investors by surprise.
We know that in the period from July 2016 through to January 2018 market volatility was unusually low. Part of the explanation was that investors were comforted by central banks’ preparedness to stamp on signs of instability to promote investor wealth and support business confidence.
With economic conditions having improved, policy makers are less inclined to intervene in response to moderate fluctuations in markets. So, investors should not be surprised by a reversion in volatility to more normal levels.
However, it is fair to note that volatility temporarily shifted to an elevated level. This episode is like the bout of volatility experienced in February and it appears to be a new reality of the short-term dynamics of capital markets. There is a growing number of risk management strategies in the market that respond to rising volatility by automatically reducing exposure. This serves to accelerate market declines and it takes time for excess volatility to dissipate and long-term investors to re-enter the market.
What narrative best explains the share market in October?
There are two important factors to consider when thinking about share prices. First, what is the cash flow (or dividend) profile the shares are expected to deliver over time? Second, given the uncertainty in these future cash flows, what is the appropriate discount rate to apply to determine an intrinsic value?
I think that most of the October move in the share market was associated with a rise in the discount rate (aka: the cost of capital) rather than a major negative re-assessment of the expectation for corporate cash flow. It would be a more serious issue for investors if we were seeing a major revision to cash flow expectations.
Further, I think that the rapid sell-off in the bond markets at the start of October, generated by evidence of a sustainably improved economic outlook, was the key source of the rise in the discount rate. There is a growing realisation that the US Federal Reserve is likely to pursue a policy that pushes cash rates to a level well above the inflation rate.
The good news is that, in this current episode, inflation expectations have remained relatively stable. It appears that expectations for real rates (ie: cash rates adjusted for inflation) have risen along with the term premium that serves to compensate investors for uncertainty. In this context, rising real rates represent a vote of confidence in the future.
To be sure, investors also appear a bit more concerned about the risks to earnings and cash flow due to higher input costs and tightening financial conditions; and that has also contributed to the rise in the cost of capital. However, in my opinion, this has been less significant than the shift in interest rate expectations.
What is the outlook from here?
As noted earlier, it makes little sense to try to forecast short-term movements in the share market other than to observe that an environment of heightened volatility does tend to persist for some time.
However, looking out over the period ahead, there are reasons to be optimistic. Importantly, there is a low probability of a US recession in the year ahead with fiscal policy continuing to represent a tailwind through 2019. While we have likely seen the peak in terms of the rate of growth in US activity, the economy is positioned to continue to expand at a decent clip. The same observations appear to apply to US corporate earnings.
Importantly, there are no serious imbalances in the US economy that require immediate corrective action. So, while the Federal Reserve may push the cash rate higher by another 1.5 per cent, that still wouldn’t be particularly restrictive by historical standards. And in any case, they have scope to change tack if conditions change.
And, at this point in time, it is appropriate to leave expectations for cash flow and dividends from equity markets largely unchanged.
Consequently, the medium-term return expected from investment in share markets today has increased modestly compared to our expectations at the end of September.
Jeff Rogers is CIO for ipac funds in the multi-asset group at AMP Capital.
