Despite rallying during the month’s last trading session, equity markets still ended October with their steepest monthly drop since May 2012. The MSCI AC World index (expressed in US dollar terms) fell by 7.6%, seriously cutting into its year-to-date performance, which is now down by 5.6%. After falling by 8.8% in October, emerging markets are now down by 17.5% over the year to date (based on the MSCI Emerging Markets index in USD terms).
Exhibit 1: Sharp fall in equities in October
Source: Bloomberg, BNP Paribas Asset Management, data as at 02/11/2018
These shifts were driven by one concern on top of another. Just as the month got started, upward pressure on US bond yields triggered a marked fall in equities as the Fed chairman’s especially optimistic outlook on the US economic situation raised fears of a faster-than-expected run-up in US bond yields. Tech stocks, broadly defined (i.e. including Internet and e-commerce giants), then gave up a big chunk of their previous strong gains, and implied volatility on equities rose.
In the run-up to the 6 November US mid-term elections, which could see the Democrats take back the House of Representatives, President Trump unleashed a barrage of protectionist statements, all the while maintaining some doubt on the state of negotiations with China. His most over-the-top comments on trade negotiations stoked investor fears.
New concerns over global growth emerged as Chinese GDP growth dipped to 6.5% in the third quarter, its slowest pace since 2009, and the manufacturing PMI fell to a two-year low. In its World Economic Outlook, released on 8 October, the International Monetary Fund (IMF) revised its growth forecasts downward and highlighted the most salient risks, including the rise of hurdles to trade, a reversal of capital flows out of the weakest emerging economies, and heightened political risk.
Despite diplomatic tensions between Saudi Arabia and the US and the prospect of new restrictions on Iranian oil exports due to enter into force at the start of November, crude oil prices declined in October, with WTI crude falling by 10.7%, on doubts on global economic activity.
Politics remains the centre of attention in Europe
Eurozone equities and the euro itself were driven down by a combination of disappointing growth and worrying political news-flow. Negotiations between the UK and the European Union appeared to be at a stalemate as key issues remained unresolved despite several high-level meetings and summits. Although an utter failure to reach an agreement looks unlikely, the balance of power within the British conservative party is making Theresa May’s job difficult.
Italy was the cause of the most challenging political obstacles. After the Italian government announced in late September that its projected fiscal deficit for 2019 would amount to 2.4% of GDP, the European Commission notified the minister of finance, Giovanni Tria, that this was an “unprecedented” breach of the rules of the Growth and Stability Pact. Although both sides insisted that talks had not been broken off, this issue kept financial markets on edge throughout most of the month.
Exhibit 2: Pressure on Italian bond markets
Source: DataStream, BNP Paribas Asset Management, data as at 31/10/2018
The major developed markets fell as follows (in local currency terms): by 9.1% on the Nikkei 225, by 6.9% on the S&P 500, and by 5.9% on the EuroStoxx 50. That said, the EuroStoxx 50 managed to outperform thanks to a weaker euro (-2.6% vs. the US dollar). Energy stocks took a hit from the decline in oil prices, tech stocks came in for some profit-taking, and industrial stocks were sold off. European banking stocks were undermined by concerns over Italy.
The reporting season was very solid in the US on both the top and bottom lines, even when allowing for the impact of tax cuts. Although the reporting season in Europe and Japan trailed that in the US, it also disappointed, as analyst forecasts were exceeded less often than usual.
The Federal Reserve celebrates solid economic growth in the US
The US Federal Reserve’s Federal Open Market Committee (FOMC) did not meet in October. The US federal funds target rate thus continued to range between 2.00% and 2.25%, in accordance with the decision announced in September. The minutes of the 25-26 September meeting, released on 17 October, showed that FOMC members are quite confident in the robustness of economic activity and the need to continue raising key rates. They plan to implement a restrictive monetary policy by rising rates above the level considered to be neutral.
The committee believes that risks to growth are balanced, with consumer confidence, financing conditions and fiscal policy offsetting uncertainties arising from US trade policy, diverging growth between the US and the rest of the world, and the shakiness of certain emerging economies. FOMC members seem to have discussed risks less than during their previous meeting.
Economic data is underpinning the optimism of the Fed and Jerome Powell, who in early October spoke of the “remarkably positive economic outlook”. GDP growth came to an annualised pace of 3.5% in the third quarter (after 4.2% in the second). This initial estimate in the national accounts reveals a big positive contribution of inventories (2.1 percentage points), which more than offset the second-quarter de-stocking.
Foreign trade detracted due to a noticeable uptick in imports, as some companies may have chosen to move their imports forward in order to get the jump on higher tariffs. Final domestic demand remained solid, driven by a 4.0% increase in private consumption, but residential and non-residential investment declined. A robust job market (with an unemployment rate of 3.7% in September, a low since December 1969) is supporting consumer confidence, although wage growth is still tentative.
In September, the Conference Board consumer confidence survey hit a high since September 2000, while small business confidence (based on the NFIB survey) approached its all-time high. Total inflation remained under control, with the consumer price index receding, on a year-on-year basis, from 2.7% in August to 2.3% in September. The personal consumption expenditure deflator, ex-food and energy, came to 2%. Futures continue to price in a high probability of a key rate increase in December, but observers are less sure that the Fed will stick to its hawkish stance after that, with rates being priced in for end-2019 and end-2020 that are well below levels deemed “appropriate” by the Fed.
Exhibit 3: Fed funds rates forecast
Source: Federal Reserve, Bloomberg, BNP Paribas Asset Management, data as at 31/10/2018
A new economic regime
The October equity market correction reflects an accumulation of concerns and was exacerbated by technical signals that led hedge funds and systematic strategies to dial back their exposure. Political news-flow (US protectionist measures, Brexit negotiations, and dissensions between Italy and the European Commission) triggered knee-jerk reactions, while investors were made somewhat nervous by doubts over the economic cycle.
It now appears that global growth has indeed slowed from last year’s robust pace. Even so, economic indicators thus far are not casting any doubt on the scenario of solid economic activity, particularly in the US.
Meanwhile, G4 central bank forward guidance suggests that the normalisation in monetary policies will continue in 2019, barring a marked downturn in the economy, and that weak inflation will be no obstacle to normalisation.
Investors are focusing on the facts that global growth is less synchronised than in 2017 and that monetary policies are less accommodating, but are losing sight of the good news. Lack of visibility on the political front could also last some time.
Investors will have to adjust to the new economic regime, which is actually not fundamentally different from the previous regime, and get used to political uncertainty, an element that is hard to factor into asset allocations except through highly tactical moves. Only then will they, at last, be able to take into account the more positive factors. Companies’ very solid third-quarter top-line figures and strong earnings forecasts for 2019 could help them do so.
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