“Not welcome, but arguably overdue”, a confluence of factors - rising yields, extreme valuations, stretched technical indicators and a rush to the exit on plenty of (increasingly popular) volatility bets - were to blame for equities taking a rain check on the good times this past quarter.
Rising bond yields, while typically a general indicator of a strengthening economy, are the bogeyman for stocks because plenty of companies finance growth through debt. Higher loan repayments, all other factors held constant, hurt earnings.
The much-watched 10-year US Treasury Bond yield was negatively correlated to the rise in equities since 2014 but started to change course over the last 12 months, particularly popping in January. While the market grew comfortable that rates would rise slower to match below-trend growth, the gargantuan USD 1.5 trillion US tax cut messed that up! With the legislation’s potential to ignite an inflation barnstormer, the Federal Reserve may have to re-evaluate its slow line dance of rate normalisation.
The post-Christmas rush into equities started flashing a huge red in ’overbought territory’, sparking a flurry of sell orders from funds that use this technical trading strategy. Record money flows into stocks were also giving a contrarian signal. Stock valuations, as measured by a much-tracked ratio, “climbed more than two standard deviations above the average of the last century – only for the third time – after the dot-com bubble and the roaring ’20s surge that ended with the Great Depression!” We didn’t make that up!
Particular mention, however, must go to the rise in volatility trading – specifically ETFs betting that volatility will keep sinking/stay low. Prior to the violent February reversal, ‘short volatility’ ETFs were backed by the most cash on record with some volatility funds now bigger than those tracking some countries! If this all feels like another possible canary in the coal mine, well, let’s just say that most of us lived through 2008 and remember the pitch, “But house prices never fall!” Personally, this writer was much more comfortable with that line about “death and taxes”!
To be fair, markets did attempt a recoup, but a wet orange blanket was thrown on that party. A particular headline-craving scatterbrain had another senior moment and realised he better try to make good on one more unfulfilled (but ridiculous) election promise: he threatened tariffs on major US imports. And in a tit-for-tat spat reminiscent of high school hijinks, China flexed its new-found bullying prowess and announced retaliatory tariffs on everything from bourbon to Levi’s! Equities reached for a bottle of Jack and groaned again the next morning.
The results were...
So, all this culminated in the All Country World Index, a broad measure of global stock prices, going down 2.4% for the quarter. This mild headline average doesn’t, of course, tell the whole story. US and European markets may have gone down 3% and 4.7% on average, but Latin American and African markets defied the gravitational pull of this stumble to finish up 5.3% (yes UP!) and flat respectively. Asia (excluding Japan) backed off a little at 1.6% but Japan tumbled 7%!
While commodities, as measured by the Bloomberg Commodity Index, hit a 2-year peak, the asset class got caught in the general downdraft, reversing course to finish flat by quarter’s end. Crude oil and gold hit 2 and 3-year highs respectively but both copper and iron ore (industrial activity markers) plunged an average of 9.5% on the back of materially slowing Chinese imports. Some analysts forecast further iron ore price pressures ahead, in the face of weaker Chinese housing market conditions. This will no doubt weigh heavily on the Australian economy and its dollar.
Globally and on aggregate, bond prices continued their upward trajectory. Yields on the benchmark US 10-Year Treasury Bond rose 11% in the last quarter alone. And as explained above, that had quite the significant impact on equities.
On the home front, the ASX200 went down 5% after hitting yet another post-GFC high in early January. But looking a little deeper we found that the healthcare sector (of which our clients typically have exposure to) not only outperformed the benchmark index but powered ahead 7%! Consumer staples managed a small positive as well. Financials, telecommunications and utilities were woeful. CBA plumbed 12-month lows and lost 10 % for the quarter while Telstra managed to summer barbeque 13% off its value for the period.
Stuck between a rock and hard place, the Reserve Bank left rates on hold at record lows and the Australian dollar (vs the USD) lost 1.5% for the quarter as the interest rate outlook (for any potential short-term hike) deteriorated in response to mixed local economic signals.
Despite yields rising (and some spiking), our fixed-income managers held their own, guiding client bond investments to an even finish overall. Allocations in our property sphere also netted out even. While international share exposures managed to eke out a small positive, our Asian, infrastructure and domestic equity investments (micro, small and mid-cap) faced small headwinds this quarter. These allocations, by virtue of where they sit on the risk continuum, typically bear the brunt in a ‘risk-off’ environment, which was our March quarter.
Escaping such a multi-triggered sell-off (like the one in early February) unscathed would require Nostradamus-like powers. To escape the US administration’s capers would simply require turning off that reality show.
The movements of the March quarter have shed light on a couple of factors investors will no doubt have to keep a close eye on in the near term. Stay with us now…
Continuing, rising yields
Globally, bond prices have continued their now 12-month-long upward march as more and more countries around the world embark on a monetary tightening cycle and inflation rears its much-desired head. The benchmark and closely monitored US 10-Year Treasury Bond Yield hit a 3-year high of 2.9%. This figure has been a bellwether for where rates are heading, including those in Australia.
Analysts are in heated debate as to where the ‘game changer’ might be. 3%? 4%? While rising rates are usually looked upon as a vote of economic confidence, not everyone is convinced America is strong enough to handle much higher rates.
Will the resulting increase in the wholesale cost of funding for our banks be passed on in the form of increases in mortgage rates, irrespective of the Reserve Bank sitting on its hands? And to what extent will that pressure home loan serviceability and, by extension, house prices? You may have already read a report doing the rounds about the eye-watering amount of ‘liar loans’ that have been written locally.
A banking Royal Commission is already underway, shining a spotlight on questionable lending and industry practices. How many of those loans will start to wobble, if not already doing an uncomfortable jiggle, when rates keep ticking up? A continued rise may indeed be the harbinger of more stock market and property price discomfort.
Unwind of crowded trades
A decade of monetary cocaine (i.e. low rates and quantitative easing) has created dizzying highs in the form of many one-way trades. These trades are now very, very crowded and the vast majority of participants are positioned one way. As we discovered with the recent sell-off, the investors behind these bets trade on very similar entry and, more importantly, exit signals. When their systems flash red simultaneously (and let’s not forget the effect of high-frequency trading compounding this), a rush for the exit is never elegant. Add to that, the massive amounts of leverage behind these bets and any collective unwind will be nothing short of a Pamplona-style stampede.
And getting back to what we mentioned at the start, there is now a growing question around (unregulated) popular inverse and leveraged volatility products and funds, and whether they could pose a systemic risk to the financial system. Plenty of novice, retail-type traders were wiped out in the February Fright. More than a dozen funds had trading halted as their values sunk to zero.
Extended low volatility has unfortunately created unchecked complacency.
The US reporting season
As much as we’d like to say it’s akin to Oscar season, the reality is much more sober (unless of course, you’ve had a few in anticipation of wading through mountains of profit reports!). Earnings season is when a large number of publicly traded US companies release their quarterly earnings reports. In general, each earnings season begins one or two weeks after the last month of each quarter (December, March, June and September).
As Investopedia has it, “The unofficial kick-off to earnings season is the release of earnings by Alcoa” (major aluminium producer and thereby a big barometer of industrial health), which is a significant Dow Jones Industrial Average component, as it is one of the first major companies to release earnings after the end of each quarter. It also coincides with an increasing number of earnings reports being released.
Given the size of the US economy, this is a very active time in the market as participants (analysts, traders and investors) review the earnings reports, which may affect their positions on or in a company.
You can often see a lot of movement in the shares of companies releasing reports as the market reacts to the new data. It’s not unheard of to see shares jump 20% or more, or to see them fall by this same amount. It’s also a highly frothy time for the financial news media, such as CNBC and The Wall Street Journal. There is extensive media coverage of the major earnings releases – from a general recap of the earnings to reporting on whether the companies missed, met or beat analyst expectations.
Just a little bit more to keep the talking heads bobbing.