October has been an unsettling month for global equity markets, seeing the S&P 500 drop by over 5% and the FTSE 100 by more than 6%. European and Emerging Market equities have fallen by -8.5% and -7.8% respectively.
A number of factors are contributing to this recent sell off, in particular concerns that corporate margins have peaked. Rising interest rates and bond yields, anxiety over ongoing trade tensions between the US and China, Brexit, Italian debt and the upcoming US mid term elections are other factors.
Whilst market sentiment has weakened significantly, it is important to consider whether the fundamental picture has deteriorated sufficiently for us to change our level of equity exposure within portfolios.
Earnings continue to beat expectations…
Following the recent sell off investors are now focusing more on earnings. With 146 companies having reported so far in the US, 86% have beaten earning expectations and 61% have exceeded sales expectations. Despite this, earnings momentum is weakening, with corporate guidance for future earnings growth lower than previous reporting cycles. Companies cite a wide range of factors from increasing costs of labour, energy and raw materials to softer demand. Investors have therefore been concerned that earnings have peaked and could trend lower into next year and beyond. It is important to note that while momentum might be less strong this does not apply to all companies, with a higher proportion of those operating in more defensive sectors either maintaining or upgrading the outlook for their earnings. Furthermore, given recent price movements, valuations of equity markets now look more attractive, with the S&P 500 trading at 16.4 times 2018’s earnings, well below the level of recent years.
…but trade tensions cast a shadow
The trade disputes between the US and China pose a risk which is harder to quantify. The disputes have the potential to threaten global growth and inflation which then might impact corporate earnings through higher costs and lower margins.
In the worst case scenario, conservatively assuming no substitution or pass-through of expenses, a 25% tariff on all imports from China has the potential to remove all earnings growth currently forecast in the US for next year. This is not our central view, but it highlights the potential impact. It is unlikely that we will see much change to rhetoric from the US before the mid terms in early November, however more positive noises on the trade dispute will certainly help improve sentiment into the end of the year.
Markets rotating in the run up to the US mid terms
The US market has behaved much as expected ahead of mid term elections, with heightened uncertainty resulting in increased volatility. The Vix index (the widely-followed measure of implied volatility also known as the “fear index”), has traded higher throughout October than at any point in the whole of 2017, albeit with the caveat that volatility last year was extraordinarily low.
It is worth noting however that previously we have seen a rally during the fourth quarter of mid term election years, with the index returning twice the median return of non mid term years over the same quarter.
Another sign of the resulting heightened uncertainty can be witnessed in the bond markets. Since the start of the month 10 year treasury yields have risen to 3.13%, and 30 year yields have risen to 3.35% as the Fed continues with its programme of monetary policy normalisation. While a steepening yield curve is typically illustrative of improving economic fundamentals, in the context of almost a decade of quantitative easing, the market seems concerned with a withdrawal of liquidity.
This is sparking a notable rotation from “growth” to “value” stocks, with fast money selling crowded “growth” positions such as tech stocks in favor of “value” stocks such as financials. Higher US rates and a stronger US dollar have further weighed on Emerging Market sentiment, particularly those countries with higher levels of US denominated borrowing.
Remain engaged in equity markets
Overall whilst we are cognisant of the increasing threats to global growth that are prevalent today, we are happy to maintain our current equity positioning across portfolios. We are unlikely to see similar returns to those realised in the last two years, however our fundamental view of strong global economic growth and corporate earnings means there is a good chance for improved investor sentiment as we approach the end of the year.
 Performance data is total return and denominated in sterling. MSCI EM and FTSE World Europe ex UK index data to 24th October
 As at 24th October 2018