Volatility returned to markets this month. The cause: a confluence of unremarkable events, which stoked investors’ fears of a global growth slowdown. Equities sold off; yields fell; oil plummeted. Strong US data and a solid start to US earnings season have since restored confidence. The recent correction should be viewed as a healthy event, rather than a harbinger of doom. Doubt often brings opportunity.
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US equity markets experienced a long over-due correction this month, with the S&P 500 falling 10% from its September peak.1 Signs of slowing around the globe (from disappointing European data to lower oil demand forecasts) threatened to derail the US’s accelerating economy and its seemingly indefatigable bull market. By the end of October, US equity markets had climbed most of the way back, as robust US economic data and a strong start to the third-quarter earnings season increased optimism that strength in the world’s largest economy would outweigh global woes.2
Volatility returned in October
We maintain our Overweight in US Smid Cap Equities, as this domestically-exposed sector should benefit most from the continued US economic rebound through the end of the year. The primary catalysts are: a confident US consumer, higher quality earnings growth, and the potential for increased M&A activity.
We increased our allocation to US Large Caps from Neutral to Overweight. US economic strength relative to other developed markets should be a tailwind for its equities, particularly those in cyclical sectors.
Non-US Developed Markets Equities
European economic data disappointed in October, corroborating doubts about the viability of the fragile recovery. The region’s equities underperformed as a result.3 On a positive note, the ECB’s Asset Quality Review (AQR) revealed a mostly healthy banking sector, which should improve confidence and stimulate lending. Continued support from the ECB, along with strong earnings upside potential and early signs of improvement in credit markets, should help propel European equities higher.
Japanese equities underperformed in October as the economy struggled to regain its footing after the April sales tax hike. However, recently released data showed that retail sales grew the most in four months in September, a positive sign that consumption is recovering.4
Prime Minister Abe is set to decide by the end of the year whether to increase the tax once more next October. Hopes are pinned on the upcoming earnings season, particularly in light of the weaker yen, which should be a tailwind for profits.
We remain Overweight Non-US Developed Markets Equities, as valuations are compelling, and policy actions should be catalysts for outperformance over the long term.
US fixed income markets continued to benefit from lower-than-expected interest rates in October. While equity markets sold off in the middle of the month, US 10-year Treasuries hit their lowest point of the year.5 Heightened geopolitical risk and doubts about global growth have increased demand for safe-haven assets, pushing down US Treasury yields. US High Yield Bonds were the worst performing fixed income segment. Spreads on these bonds widened during the market pullback as investors fled risk assets.
Improving US economic data, particularly in the labour market, is building pressure for the eventual increase in interest rates. Rising rates will hurt fixed income investors, especially those with passive, long-duration exposure. We remain either Underweight or Neutral fixed income assets for this reason.
We are Neutral on US High Yield Bonds. The higher coupons do not compensate for the risk of principal loss from widening spreads, particularly in light of deterioration in underwriting standards for leveraged loans.
Emerging Markets Bonds
Emerging Markets Bonds rose less than 1% this month after selling off in September.6 Weaker global growth prospects led investors to anticipate lower US rates for longer, making Emerging Markets Bonds a more attractive yield source. However, with a stronger US dollar and more volatile political landscape, yields do not seems to compensate for the additional risk.
We are Underweight Emerging Markets Bonds due to an unfavourable risk-return profile in light of geopolitical concerns, the potential for continued currency volatility, and impending tightening in the US.
Slowing global demand and a stronger dollar pushed down commodity prices this month. Oil prices hit the lowest level since mid-2012, falling 25% from this year’s peaks.7 The supply side of the equation is also not working in oil’s favour; US shale production has created a glut in the market. Prices for most industrial metals also fell with slower demand.
We are Underweight Commodities, as a stronger dollar, slowing global demand, and excess supply, in some sectors, will continue to put pressure on prices.
REITs kept their place as the best-performing asset class year-to-date with returns in excess of 20%.8 REITs have benefited from lower-than-expected interest rates, which bolster the appeal of REIT dividends for yield-hungry investors. Lower energy costs have given a lift to earnings in some sectors, such as hotel REITS. Apartments REITs have been among the top performing sectors this year, but demand will need to outpace new construction for this outperformance to continue.9
We are Neutral on REITs, as the transition to a normalised interest rate environment could put downward pressure on prices.
Emerging Markets Equities
Emerging Markets Equities struggled under the weight of geopolitical strife in October.10 Russian equities were among the hardest hit with the combination of lower oil prices, increased sanctions, and soured sentiment causing cash to flee. Meanwhile, Brazilian equities sold off in response to the re-election of incumbent President, Dilma Rousseff, as investors anticipated four more years of corruption and economic stagnation. Slightly better-than-expected GDP and manufacturing data buffered Chinese equities, which ended the month better off than most of their peers with approximately flat returns.
We maintain a Neutral weight on Emerging Markets Equities. Wide disparity in valuations bodes well for actively managed vehicles. While tightening in the US may temporarily pressure EM equities, this should be offset by stronger external demand from developed markets.
Alternative Trading Strategies
Our Overweight to most Alternative Trading Strategies is a hedge against anticipated variability in asset prices, as markets adjust to the decreased pace of US monetary stimulus. Relative Value has benefited from declining correlations in US equity markets, and Event Driven strategies have outperformed due to a pickup in corporate actions, particularly M&A. Meanwhile, Global Macro funds suffered from the drop in interest rates.11