Update on Market Volatility: Commentary from Mackenzie's Chief Economist
November 1, 2018
Alex Bellefleur, M.Ec., CFA
Vice President, Chief Economist and Strategist, Multi-Asset Strategies Team
October was a volatile month for global equity markets, with the S&P 500 down approximately 7%. Government bonds provided little in the way of effective protection for investors, as the Bloomberg Barclays U.S. Treasury Aggregate lost about 1% over the same period, reversing the historical negative correlation between bond and equity returns that has prevailed over the past few decades. How do we explain the recent market action and where do we stand?
U.S. economic growth is decelerating from high levels. For example, this is evident in the ISM Manufacturing Index, which has begun to moderate from recent heated, somewhat unsustainable levels. There appears to be no immediate concern about the U.S. economy entering a full-blown contraction; the current market focus is more centered on a slowdown in the pace of growth, while remaining positive. As the effects of the recent fiscal stimulus (i.e., tax cuts) gradually disappear and as interest rates move back closer to neutral, this is a natural development for the U.S. economy.
However, of more specific concern to markets has been the combination of this second-derivative slowdown in growth with continued increases in bond yields. Typically, weaker economic data would be accompanied by lower bond yields which, in turn, would provide a cushion to a slowing economy. This has not been the case in recent months, with yields continuing their ascent. There have been a few reasons for this. At the short end of the yield curve, the Federal Reserve does not appear to have shown inclination to change its view on its current normalization of monetary policy, remaining committed to its gradual rate hikes. Another issue leading to higher bond yields has been the realization that the U.S. economy and labor market show few signs of spare capacity. Job openings, for example, recently surged to new highs, indicating potential wage pressures in the months ahead. Reflexively, these continued increases in bond yields have amplified a growth slowdown that already was taking place in some interest rate-sensitive sectors such as housing, where home sales have continued to slow.
For the stock market, this has created an awkward mix, as the market has priced in: 1) a moderation in growth in the months ahead, but 2) at higher discount rates. This is a double whammy that has led to lower price-to-earnings multiples for most global equity markets.
The October volatility has not been strictly U.S.-centric. Continued trade tensions have created difficulties for China and several other emerging markets, which are seen by investors as being more exposed to global trade risks than the United States. As a result, pressures on China’s currency began to appear, with the People’s Bank of China spending some of its foreign exchange reserves in defense of the renminbi’s value. Recent news on U.S.-China trade have sounded more positive of late, but much will hinge on the outcome of a potential Trump/Xi summit at the G20 Meeting in Buenos Aires on November 30 and December 1.
Finally, tensions in the Eurozone have remained in place, with Italy’s newly-elected, populist government tabling a budget with an expanded deficit that was poorly received by the European Commission. Italy’s heavy sovereign debt load, standing at over 130% of GDP, requires contained budget deficits and affordable interest rates to remain under control. In a context of slowing growth, any challenge to one of these two assumptions affects the value of Italian government bonds negatively, in turn hurting Italian banks, which are heavy holders of the country’s sovereign bonds. As a result, we saw a significant widening in Italian bond spreads over German Bunds as well as a fall in the euro versus the dollar. As the ECB prepares to end its quantitative easing program in December, the ability of Italy’s government to obtain affordable financing to stabilize its debt-to-GDP ratio remains of key concern to the Eurozone.
Where do we stand? The Multi-Asset Strategies Team has been positioned cautiously on the bond market since October 2017 and price action has broadly confirmed our tactical positioning. Our views on this asset class have not changed in recent months: at current levels, we continue to see poor value and macro drivers for the bond market. As a result, we remain tactically underweight fixed income assets. With respect to equities, our assessment of valuation metrics or macro conditions has not changed materially. However, we do believe that we have moved to a higher volatility regime and our reading of investor sentiment has deteriorated slightly. In this context, our tactical equity positioning is slightly lighter than it was a few weeks ago.