October 2018 – The panic

October 2018 – The panic

October has been an extraordinarily volatile month; this unusual volatility surfaces every several years and has little to do with the quality of investments or their long term outlook. Individual share intra-day falls, asset rotation, and risk aversion have reached levels unseen since the 2010-2011 European peripheral countries crisis.

When facing periods of heightened turmoil such as the current one, we need to take a step back and analyze market fluctuations to analyze at what point of the cycle we are in and take the best stance to make the most of the recovery which always follows tempests.

Why has there been such a sharp and messy rotation in the world’s principal economy?

To understand this market scenario, we need to go back to January 2015 (3 years and 10 months ago) when the Fed first stopped expanding its balance sheet. Interest rate hikes started in December 2015 and there have been 8 rises more since, that have brought rates to the current range of 2.00% – 2.25%. In January this year, the Fed’s restrictive policy tightened considerably: it started to reduce its balance decreasing the supply of money; to date it has withdrawn around USD 300 billion from previous maximums. On the other hand, Trump signed a fiscal reform in December 2017 which effectually reduces the budget in USD 1.5 trillion over the next 10 years. The combination of both these levers has given rise to a policy that is more restrictive than expansive, and this has an obvious impact on future growth perspectives, which could worsen if the four announced rate rises (including the one planned for December this year) do take place in 2019.

With regard to trade policy and earnings outlook, trade war has lowered growth projections and margins in crucial sectors such as the automotive, consumer cyclical and technical components industries. In addition, higher interest rates have increased financing costs, slowing down the demand in housing and real estate investments. On the up side, the TMT and consumer discretionary sectors have continued to outperform expectations amidst the threatened tax rises for technology companies, and conservative profit forecasts curbed by the numerous hurdles companies are facing.

The consequences are being felt in 2018: the headlong collision of expansive forces (Trump’s fiscal reform coupled with corporate record profits) and restrictive forces (Fed balance reduction and interest rate rises, import tariffs, and breaking or revising trade agreements) have spurred volatility and risk aversion right on the verge of the elections to the Senate and House of Representatives in the US; it’s like accelerating and braking at the same time and waiting to see what happens.

While in Europe restrictive policies have not even begun, the combined political uncertainty, excess burden of taxation, and lack of regulatory coordination in industries that are vital for competition with the main economies, are putting on the “brakes” and the ECB does not need to take further actions.

China is also starting to feel the effects of tariffs and has started to implement corrective measures (currency depreciation and specific aids to the car industry).

So, how did this year go?

The equity of more cycle-dependent companies has accumulated losses since January this year, i.e. 10 months. Interest rate hike in the first three quarters and its effect on 10-year US bonds have dragged the performance of more defensive companies (bond proxies) vs. the good performance of growth companies or non-traditional cycle-companies such as technology. Early in the 4Q, the polarity of growth and defensive shares made markets giddy and magnified all external news, constraining future expectations and justifying the current sharp rotation towards defensive assets which is only comparable to periods of real recession.

Where do we stand now?

The optimism discounted until now has almost vanished completely. On the contrary, markets are now discounting a quite uncertain future where companies lower their forecasts against an unsettled political scenario. However and in spite of the moderation of their estimates, quality and stable growth companies continue to post record returns. We are half way through the growth moderation process of the cycle and there are no signs that any main economy will finally end in a recession. In circumstances such as these, it is quite likely that company valuations are at overbought levels, increasing their attraction. Also, it is not unusual for indices to bottom out months before there are signs of recovery in growth forecasts.

What can we expect going forward?

All the factors that have triggered this crisis are external to companies (monetary, fiscal, and trade policies, etc.), and therefore are decisions politicians could quickly revert should economy shows signs of real weakness. In fact, US 10-year rates are already at levels that are proving detrimental to more sensitive sectors (e.g. the Real Estate and automotive sectors, which are more dependent on financing), and this could make the Fed reconsider the announced rate increases. Haunted by recent crises (sub-prime crisis in 2007, Lehman in 2008, European peripheral countries in 2010-2012, China in 2015-2016), private sector companies have implemented preventive measures aiming at offer-contention and balance sheet equilibrium. Barring new external factors that could stagger investor confidence, given current corporate earnings announcements, we feel stock exchange prices are at sufficiently attractive levels to face the next months with assurance.

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