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Market Volatility (continued...)

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25 days ago (25 Oct 2018)  |  

From the Desk of the CIO;

 

We noted a few weeks ago when this recent bout of volatility started, that market bottoms (whether interim or long term) take a few weeks to play out and this correction is no different in that respect. What is evident in this latest episode is how US stock markets have fallen from the new highs reached in September to wiping out full year gains in just a few short weeks. This is symptomatic of the world we live in, where better-than-average returns are associated with a high level of short-term volatility. This volatility helps avoid the excessive bullishness of big market tops that we saw in 2007 or 1999. We have often cited the bull market that started 10 years ago as the most hated bull market ever. This is despite the S&P 500 returning 11% pa compound over the last 5 years (and 14% pa if you take a 10-year time frame). Many investors gave up the cult of public equity investing in disgust following the horrors of 2008. Scars are deep and fear is implicit in the consistent out-flows from active managers over the last decade. These are not the typical characteristics of excessive bull market behaviour.

 

So what is the market worried about?



Yesterday’s moves were exacerbated by the parcel bombs that were distributed to the liberal leaning ex-presidents and supporters, which heightened market anxiety. These levels are attractive for investors looking for reasonable long term returns (and accepting of volatility). In terms of fundamentals, earnings growth in the S&P 500 is running at 20% year-on-year and is expected to slow to 8% for next year. The adjustment to slower earnings provides reasonable justification for a slow-down in the market’s ascent, but not for a correction of the magnitude we have seen. We re-iterate our view that the Federal Reserve is closer to a pause in rates than it is to raising rates recklessly until they cause a crisis. We have some concerns about the possibility of a “hard” Brexit and woes persist regarding the Italian Budget negotiations with the EU and all this is occurring in the midst of an auto-led slow down in Germany. We also note tensions concerning China trade tariff talk, something that continues to be an own goal for Trump as the costs of doing business escalate as a result of the tariffs, particularly in the “old economy” companies like autos, tractors and machinery. 

 

So what can turn this market around?



In short, continued good earnings. The ratio of earnings and revenues beats for Q3 for the S&P 500 is in line with the historical average despite high expectations. Other factors that we expect to play a role include: a Federal Reserve that is less hawkish in their impending rhetoric; a Trump deal with China or at least the notion of one that stops at 10% tariffs rather than the 25% threatened from next year; Chinese policy stimulus which is now building as China grapples with their push-pull de-leveraging; a softer Brexit; positive resolution of the dispute between the Italian government and the EU.

 

So what are the favourite equity markets?



We remain over-weight in the US and Japan with the latter seemingly accelerating as we approach the 2020 Olympics. Japanese valuations also look abnormally low against an unusual background of lacklustre market performance and strong earnings. It is noteworthy that Japan registered a record short-interest ratio (i.e. the biggest short ever in Japanese stocks) which suggests an almighty short-squeeze is possible. Europe is a 2019 story, so we re-iterate our view to buy on weakness in Q4; Europe will look better in 2019 when Brexit negotiations are less fraught (possibly due to an interim agreement) and Italian negotiations are over. Within Emerging markets we favour China right now, given the chances of stimulus and on the basis that Trump might become a friend after all!


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