Welcome to Fall
The equity market correction, led by the FAANGS, ahead of the US Labor Day holiday may or may not turn out to be sustained. There are plenty of commentators arguing, and hoping, that it will be on the basis that the value of the US equity market does not reflect economic reality. Assigning big fundamental explanations to short-term moves is difficult though because there is every chance that a 5% decline in the Nasdaq is seen as a buying opportunity. Global equity returns have, however, been well above their long-term average so a correction to the mean was on the cards. On that basis, fixed income markets are more attractive, especially high yield and emerging market debt. European high yield has lagged and with a 4% index yield, some 3% above investment grade, should do better.
Shock – stocks go down
Maybe because of my fixed income background I’ve always found it much harder to match moves in equity markets to macro-economic developments, especially the kind of short-term moves which saw US equity markets nose-dive on Thursday, September 3rd (when there was no surprising macro news). While the constituents of the equity market reflect the broader economy, as do the credit markets, there appears to be a much wider array of influences on performance than is the case for bonds. Valuations, particularly, sit on shifting sands while technical factors can dominate short-term moves. That has been evident in recent weeks, especially with the largest technology stocks. I very much get the argument of why technology stocks should outperform over the long-term given our evolving economy and the changes to work and life that have resulted from the pandemic, but recent moves have been excessive. The apparent increase in small retail investors, the apparent rise in option related trading and the likely increase in both, encouraged by recent share splits, have contributed to the speculative nature of the market in recent weeks. It has left institutional investors in the uncomfortable position of having some of the bigger stocks simultaneously represent their largest holdings and largest underweights. The correction seems to be classic profit taking and, unless someone bought these shares in the last week, outright losses are likely to be limited.
Fundamentals and speculation
I will leave it to better informed experts on US equities to make the point that some of the mega-caps that have led the market rally since March face potentially difficult headwinds coming from regulators and policy makers in the months ahead. I would say though, that the demand for the products and services of those companies is going to remain strong and global. More advanced mobile devices, the building of the 5G infrastructure, increased demand for greater and more robust connectivity, the decentralisation of types of economic activity and entertainment and all aspects of how digitalisation will contribute to the carbon transition make me a technology bull. Of course, I acknowledge that these are the very reasons that speculative excesses emerge as investment into companies that benefit from these trends will always be based on expectations of what the future brings and, as we know, the future is never quite as we expect it. Hence the volatility and the impact on the rest of the stock market. This week’s correction is welcome, it may go further, but I am sure that this will be seen as a new buying opportunity for many.
Change in leadership?
If we are in for a period of lower equity markets and increased volatility, I can assure you of two things. One is that there will be hysterical calls for even more policy support for markets. That has already begun overnight with market news commentators looking for a response from the Federal Reserve (Fed). The second is that those who for months have been saying that the markets are disconnected from the economy will be claiming “I told you so”. The thing is that the equity move comes as economic activity is slowly increasing and as prospects for a breakthrough on a vaccine to combat COVID-19 are rising. Yes, infection rates in Europe are climbing but in the US, they appear to be passed the recent peak. Moreover, morbidity and mortality levels are much lower than they were in the spring, meaning less pressure on hospitals and less need to re-introduce severe lockdowns. You might argue that this is itself a reason for the tech sector to lose its leadership – if economies are getting back to normal and people are going back to work the momentum behind stay at home stocks will slow and some of the more beat-up sectors of the stock markets (cyclicals and value) will do better.
The timing of the equity set-back is interesting though. I’ve recently looked across asset classes comparing the total returns over rolling 12-month periods against the long-term average performance. The last six months have seen returns in many asset classes increase to sit very close to their long-term run-rates. Global equity returns, led by the US, are above their long-term average levels by quite a margin, as are US corporate bond returns. Government bonds are bang on their long-term averages and the level of yields and policy rates will make surpassing those return levels very difficult. In the fixed income world, high yield and emerging market debt look the most attractive given that the improvement in returns in recent months still leaves the short-term run rate lower than the long-term average. In fact, emerging market bonds and equities have some relative value attractiveness. The bull case for emerging markets would be that US yields remain low, the dollar stays relatively weak, and emerging economies are able to gain access to vaccines when they become available.
Credit returns have lagged
Monetary policy is going to remain very supportive as central banks try even harder to increase inflationary expectations. Fiscal policy won’t be (and can’t be) tightened any time soon. The global economy is recovering, albeit conditional on further progress in managing the pandemic. These are reasons to stay relatively positive on the outlook. However, some correction in markets returns was on the cards because it is hard to argue that returns from any asset classes should justifiably be above their long-term average right now. So, we could see a rotation of market leadership from growth to value in equities, see the gap between US equity returns and the rest of the world narrow, and see a further modest rise in total returns from high yield credit and emerging market debt. After the risk-off rout in March I argued that, given where credit spreads had risen to, high yield markets would deliver very strong subsequent returns. They have not quite fulfilled that expectation yet but remain on the road to that goal. European high yield has lagged and, of the 12 fixed income indices that I track to represent the most diversified evolution of the bond market, European high yield brings up the rear in terms of year-to-date performance. If all the reasons why people are more bullish on the euro and on the macro-outlook for Europe given the ECB’s stance and the agreement on the Recovery Fund, then these are just as valid reasons to be positive on European high yield credit.
Equities could still correct
The biggest technical risk – from a mean-reversion point of view – is with global equities right now. To bring rolling 12-month returns back in line with the long-term average suggests something as much as another 10% correction. That is not a forecast, just a risk. But then overlay that with political uncertainty and potential disappointment that the Fed will fail to provide further information on how it proposes to evolve its policy took-kit in order to achieve its “average inflation target” and it could make for an interesting fall. Credit returns have eased back a little in the last month (US corporate bond returns were -1.2% in August), so they are somewhat less exposed to a performance set-back. A little portfolio re-balancing from stocks towards credit might not be a bad idea right now.
In the UK, children have started to go back to school this week. The government is encouraging people to go back to their offices too. The return to normality – whatever that will eventually look like – is happening slowly and not without set-backs. It is going to be well into 2021 before bars in The City are full to the brim again. We may even see some crowds in football stadiums in the weeks ahead as the new Premier League season gets underway. I was pleased to see Manchester United securing the transfer of Donny van de Beek from Ajax this week, adding to what is already a potent midfield. At this stage, I am confident that United will be able to challenge at the top of the league and with the addition of a couple more signings, why not? In the meantime, I will be watching games live-streamed on my mobile device while I sit on my connected stationary exercise bike at home waiting for shopping I ordered online to be delivered. Who said tech was dead?