Assessing the market correction
Global equity markets lost further ground overnight as investors continue to be rattled by a combination of factors. We take a look into what's causing the jitters and weigh up the impact on equities. Our view is that investors should re-enter only gradually.
Overnight, global equities continued their recent sell-off. Once again, US equities led the market lower, with their Asian counterparts following once their market opened.
Interestingly, emerging markets continue to outperform in this correction, with China registering only about half the US declines, even including this morning's move lower.
Interest rates, trade and corporate earnings fuel continued correction
They include the bumpy and uncertain path to global interest rate normalization, ongoing uncertainty around US-China trade relations and fears of contagion from the standoff between Europe and Italy.
There has also been some disappointment in the corporate earnings season and fears that we might be seeing peak profits in the USA. So far, this earnings season has seen companies on net beat albeit lowered earnings per share forecasts. However, guidance has been concerning, especially of certain companies that are viewed as bellwethers of the global economy.
Concerns over cracks in the US earnings shield
Very strong corporate earnings have protected the USA from many of the macro issues that have plagued other equity markets this year. Concerns are now growing that this earnings shield may diminish in future, which is putting 2019 forecasts in doubt and exacerbating the generally held view that the market is expensive.
Recent statements from Federal Reserve (Fed) officials that suggest a more hawkish stance become a much larger issue in this context. If the earnings season were unambiguously strong, higher real yields would likely be viewed as indicative of continued strength in the economy.
However, if longer term earnings forecasts start to fall while the central bank is tightening financial conditions, this is clearly much more of a concern, especially given the recent generally disappointing purchasing managers' indices (PMIs) across the world.
Sell-off now overdone
In reality, these fears are likely too binary. Growth and earnings are not falling sharply, and while we may be at or close to a peak in US earnings, this should be thought of more as a process than a discrete event.
The PMIs have likely been negatively impacted by a combination of one-off factors related to bad weather and the impact new emissions regulations have had on the European auto sector.
In the USA, the most recent flash PMI was actually stronger than expected. Moreover, even if earnings per share have peaked, while this would limit the extent to which multiples can expand further, it is not a reason for stocks to fall 10%.
Additionally, it is important to remember that the Fed is hawkish because they believe that the economy remains strong. If this turns out to be incorrect, they will surely adjust policy accordingly.
Several positioning indicators also suggest that the sell-off is now overdone and what were quite extreme imbalances in positioning within equity markets have likely led to forced liquidation of positions by some market participants, exacerbating the moves lower. Our global risk appetite indicator has also ticked up recently.
Not a global growth shock
The fact that global yields and commodities have held up in the face of the equity sell-off also suggests that this is not a global growth shock.
Additionally, as mentioned, emerging market assets have not underperformed in the most recent phase of equity weakness. In fact, emerging market currencies (TRY, BRL) have even rebounded strongly in the past month.
Further measures recently announced by Chinese authorities to direct credit toward the private sector in China are encouraging, and we regard those as a potential trigger for a more meaningful recovery.
So, while the ongoing setback is certainly challenging for portfolios, we find no obvious signs of something more sinister in this correction. We would maintain a small equity overweight in portfolios, focused on emerging markets and Switzerland, while keeping an underweight position in the Eurozone.
Clearly it is very difficult to time markets this volatile, which is why we continue to emphasize that investors should not rush back in, but add exposure gradually in areas where value is most attractive. We do not advocate selling into this correction.