Hello and welcome to this month’s equity market review with me, Ritu Vohora.
A blast of Siberian weather dubbed "The Beast from the East" has sent temperatures plunging across much of Europe. February also saw shivers sweep across the stock markets, with concerns around rising inflation and bond yields, handing global stocks their worst month since 2016.
Investors have been focused on movements in the US 10-year Treasury yield, which marched to their highest level in four years, and the implications for risk assets.
As volatility spiked, the longest stretch of consecutive positive months for the MSCI All Country World index ended in February - as equities dropped 4.1%. Japanese equities fell the least while the FTSE 100 fell the most. Emerging markets lagged the global index but continue to lead performance year-to-date. The dollar strengthened over the month, recovering from 3-year lows.
From a sector perspective - the sell-off was broad based. All sectors except technology hardware fell during the month. Technology was the best performing sector on a relative basis, with consumer discretionary and financials also performing relatively well. Energy was the laggard, with a stronger dollar proving a headwind.
Across most regions, value lagged while quality and momentum largely outperformed.
February highlighted the difficulty and potential costs of trying to time the market, the worst week since 2016 was followed by the best week since 2015. Those who kept calm and stayed invested were rewarded.
Greater volatility across equity markets, saw the VIX Volatility Index rising to its highest level in more than five years. Arguably though, quantitative easing has pushed volatility to artificially low levels over the past few years. So, are we back to something more normal? What’s interesting to note, is the pick-up in volatility witnessed this year is different in nature - it’s not about risks stemming from Greece or China. But rather, about valuations.
We’re in an extended bull market and with markets hitting historical highs - valuations in certain regions, especially the US are looking stretched. Since 1980, every year has seen a correction of more than 5% except for 1995. After a run of 2 years without a greater than a 5% pullback, markets were poorly positioned for a shock heading into February. Especially after a very tranquil 2017. There are various explanations for the pick-up in volatility. Including investors pricing in the potential for higher inflation and therefore rising bond yields, more technical reasons related to market structure and the unwinding of crowded trades - such as short volatility positions. Importantly though, it has been less about a deterioration in the global economy and the sell-off has been predominately contained to the equity markets.
In many ways, the recent correction was a ‘healthy pause’. Calmer market conditions, with the VIX volatility index returning to its long-run average, suggest that extreme investor positioning has reset, which should make markets more resilient. However, complacency should be kept in check. The “goldilocks” environment of low inflation, low interest rates, and ample central bank liquidity has clearly supported asset values, and investors are therefore likely to be more sensitive as central banks start to normalize policy. The bull market, although likely still intact, will be met with sharper bouts of volatility and a greater frequency of pullbacks. But greater uncertainty and rising volatility are a normal feature of a maturing business cycle.
Rising volatility and yields imply equity valuations should be lower going forwards. But it’s not as straightforward as bond yields up, stocks down.
Increased volatility brings with it lower correlations and increased market breadth – this advocates that being active and selective will be increasingly important.
There are certain areas that could be more vulnerable. So-called 'bond proxies' have been the darlings of investors looking for safety and yield. Many have re-rated without earnings support and some have seen their leverage triple relative to the market. Investors have rewarded the use of debt to pay dividends, but rising yields will be headwind, as the cost of borrowing increases. At the same time, if investors are finding bond yields more attractive again, these stocks could face a double hit. More broadly, highly leveraged companies could be at risk as well as those trading on high multiples, that do not have a sustainable earnings growth.
On the other hand, financials, often the most highly correlated sector with bond yields, could see a boost to lending margins as the yield curve steepens. The growth prospects of European banks are undervalued and they should benefit from revenue strength as well as yield sensitivity. Certain cyclical sectors such as industrials or materials, and technology could also be beneficiaries from a pick-up in inflation expectations, as increased cost pressures are typically a sign of a healthy economic backdrop alongside increased pricing power.
Staying the course in equities still makes sense for a number of reasons. Valuations are around fair value outside of the US and fundamentals remain strong - the global macroeconomic environment continues to improve with synchronised global growth, the earnings backdrop is encouraging, monetary policy is still accommodative and central banks are likely to move gradually. The equity risk premium remains elevated, compensating investors for risk. Risk-asset breakdown isn’t imminent, unless the Fed hikes aggressively under its new Chair, Jerome Powell.
However, we are entering choppier waters and returns are likely to be slimmer in 2018. We could see a rotation in leadership across different sectors and styles. Being selective in areas of the market that have fundamental value will be key.
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That's it from me and see you next time.