The October Slump

19 October 2018

The past week or so has been a volatile one for markets, with US equities leading the way in selling off sharply following a steep decline in Treasuries the previous week. Here, we put this fall into context and examine its causes.

Last week, the S&P 500 fell 5.3% over the course of two days. Global equity markets have since been pulled lower and Treasuries and gilts have reversed some of their losses. Britain’s flagship index, the FTSE 100, now stands just above 7,000, down from its peak of over 7,800, putting it into correction territory.

However, we should put this into context. The FTSE 100 is back to where it was in March this year, whilst the S&P 500 is back to where it was only in July. This decline follows a (US) market that has tripled since 2009 and had zero volatility in 2017.

Extreme market moves increasingly common

Episodes like these, where the market has a spasm of volatility, are becoming increasingly common. This is the twentieth time since the bear market ended in 2009 that the S&P 500 has had a one-day loss of 3% or more.

The VIX index is a good measure of market volatility and it is interesting to look at its record over the period since the crash of 1929. This timeframe obviously includes a host of events that one can readily associate with extreme volatility, including the Great Depression, the Second World War, the Cuban missile crisis, the 1970s oil spike, the two gulf wars, the 9/11 terror attacks and the 2008 financial crash.

So it is extraordinary that, of the twenty-five biggest spikes in volatility (as measured by the VIX) over this period of nearly ninety years, the majority have happened since 2010 – a period when the global economy has been growing consistently and there has been no major conflict. These outliers seem to be the by-product of risk aversion, liquidity conditions and fleeing investor confidence.

Rising interest rates

One cause of this latest spasm appears to be concerns over interest rates’ rising faster than expected: a replay of February’s sell-off. The US Federal Reserve has been making hawkish noises recently, which seem to have spooked investors.

Interest rates, along with corporate profits and market sentiment, are one of the key determinants of share prices, and rising interest rates are generally bad for shares. First, higher interest rates have an adverse impact on corporate earnings (i.e. it costs companies more to borrow, so reduces their profits). More importantly, as yields rise on low-risk assets like US Treasuries or UK gilts, shares become relatively less attractive. Investors ask: why invest in a high-risk asset like a share, when I can get a decent return from a gilt?

Sound economic fundamentals

Whilst President Trump’s attacks on the Fed have been attracting plenty of coverage, the fundamentals underpinning the US economy appear to be sound. Growth is running at around 3.5%, and last week’s payrolls report looks healthy after adjusting for hurricane disruptions. Corporate profits are rising very sharply, driven by the strong performance of the economy and reinforced by the cut in corporate tax rates. We are now entering the Q3 reporting season: S&P earnings are expected to be around 21% higher year-on-year.

America, along with the rest of the world, will enter a recession at some point; that is how every market cycle ultimately ends. The consensus is that this will not happen until about 2020 at the earliest. We are growing more cautious on the world economy, with signs that global trade is easing and that China is slowing. However, we see no sign of an imminent recession. Predicting stock market returns on a day-to-day basis is a fool’s errand. But valuations continue to look reasonable, as earnings have kept up with share price rises. With this margin of safety, particularly for higher-quality companies, we believe the stock markets – both in the US and UK – still offer long-term opportunities.