What a difference a few months make. Through September, the S&P 500 was delivering an impressive return on a year-to-date basis, especially relative to most other equity markets and asset classes. Alas, after an abrupt correction in October, the S&P 500 has been swinging between -2% and +5% for the year. Commentators are quick to attribute these swings to every headline around the Fed’s rate-hiking plans or progress (or setbacks) in the trade negotiations with China. However, there are some consistent trends underlying the headline changes that are reinforcing our cautious view.
What is going on inside the market?
The S&P 500 is down over 9% since the peak on September 20, 2018. Energy has been the worst-performing sector, consistent with WTI oil’s 27% plunge over the same time period. Sectors particularly levered to growth are getting hit hardest: Materials, Industrials and Financials have all fallen over 11% since the market highs. On the other hand, traditionally more defensive sectors have outperformed. Utilities, for example, have outperformed the broad market by around 14%. The Real Estate and Consumer Staples sectors are barely treading water. It seems clear that investors in the stock market have been seeking safety.
This trend has caused an interesting reversal that can be seen on the company-specific level. Companies like Amazon, Apple and Alphabet had spectacular performance through September that pulled the S&P 500 higher. Now, Apple is almost 30% below its recent high, while Amazon and Alphabet are close to 20% below theirs. Meanwhile, stalwarts like Procter & Gamble (-1%) and Pfizer (-5%) are only slightly below their respective recent highs.
What is happening outside the United States?
Outside the United States, stock markets have been under pressure all year. While U.S. stocks are still outperforming the markets of other regions this year, the gap is closing. Since the U.S. peak in September, European, Chinese and broad Emerging Market equities have outperformed the U.S. Despite this relative outperformance, looking beyond the index level suggests that Emerging Market and European equities are still pricing in challenged outcomes. In Europe, 56% of stocks are more than 20% below their recent highs (i.e., are in a bear market). In Emerging Markets, that number is 66%.
European equities are experiencing some unique challenges. Our colleagues in London note that the companies in the STOXX 600 index are intrinsically linked to global growth and trade, so worries in both areas can cause acute price declines. The composition of the index does not help, either. Energy is 6.5% of the STOXX Europe 600 (the highest of the major global indices), so oil’s slide has an outsized impact. On a company-specific level, both German automaker Daimler and Deutsche Bank continue to struggle. The two companies combined have lost over 40 billion euros in market value this year.
What is going on with interest rates?
In late August, U.S. 10-year Treasury yields were around 2.8%. By early October, they had surged to over 3.2%. This helped to spark the recent stock market swoon. As growth-levered assets like stocks have been declining and credit spreads (or the amount of yield on a corporate bond above that of a risk-free bond like a Treasury) have been widening, Treasury yields have fallen back towards 2.8%.
While investor positioning could have impacted the pace of the move lower in treasury yields, it seems to us that it mostly reflects a more pessimistic outlook for future growth. In large part because of the rally in long-term interest rates, the Treasury yield curve (or the difference between 10-year yields and two-year yields) has collapsed to its flattest level of this cycle, around 14 basis points. It appears the bond market is telling us that we are still very much in a late-cycle environment.
What about the Fed?
No discussion about interest rates is complete without mentioning the Federal Reserve. While the Fed’s own projections suggest that they will raise interest rates three times in 2019, markets are only pricing in one hike for next year. This is in part due to the growth worries that are reflected in both equity and fixed income markets, and because the Federal Reserve has seemed to moderate its tone around future hikes in its communications. In our view, the market is a little low. Tight labor markets are driving wages higher, and the Fed will likely be keen to keep inflation in check. Further, broad financial conditions are still easy. Both seem to support our view that the Fed will continue to raise rates in 2019.
Putting it in perspective
This year has felt particularly volatile. Especially relative to 2017, which only saw eight trading days in which the S&P 500 experienced a move of 1% or more in either direction. By contrast, there have already been 57 days with a 1% swing in 2018, which is already above the post-financial crisis average of 53. These market swings are likely to continue around every headline that mentions tariffs and Fed policy. However, we are trying to focus on what we believe are more powerful market drivers. Namely, we believe that:
- Tight labor markets, rising wages, and still easy financial conditions should convince the Fed to continue raising short-term interest rates.
- Economic data is likely to moderate as the boost from U.S. fiscal stimulus declines.
- Trade uncertainty is likely to continue weighing on sentiment absent major progress by both Chinese and American negotiators.
Our cautious view has been reinforced by both the composition of the recent equity sell-off and the moves in the bond market. Therefore, we believe that it is important for investors to use possible upward swings as opportunities to continue to de-risk portfolios by moving up in quality, extending duration, and moving to less cyclical sectors.
For ideas on how to incorporate these views in a way that is suitable for you, we invite you to contact your J.P. Morgan representative.
Jake Manoukian, Client Advice and Strategy, J.P. Morgan Private Bank