Equity markets generally delivered strong returns
The MSCI All Country World delivered 5.1% in Q3, with most major markets providing positive returns:
Brazil was a notable standout on the positive side, in part reflecting an unwinding of the episode in Q2, which we have previously discussed. The continued strength of emerging markets has begun to attract investor flows, which marks a strong contrast to perceptions of emerging markets when Fed policy tightening last dominated market commentary in 2013.
The natural temptation with charts like the above is to look at the conspicuous weaker markets, Spain and Australia. Spain had tracked the German market downwards for the first two months of the quarter, seemingly in reaction to the Euro strengthening which began in early April.
More recently however, the German market has turned upward (roughly coinciding with some Euro softness), while Spain has lagged. With events over the weekend, it is tempting to say this was in anticipation of the Catalan referendum, but it is also worth noting the extent to which Spain had outperformed prior to April.
What is perhaps more interesting is the differential behaviour across European markets, which has not been much in evidence in the period since the financial crisis. It remains to be seen whether the weekend’s events impact Spanish markets independently (as they have done so far today), have a more correlating effect on Eurozone assets, or prove to be more temporary in nature. Interestingly, the impact of September’s German election has been muted so far.
The Australian market similarly appears to have been held back somewhat by currency strength, but as figure 3 below shows, the market is also one of few not to grow its earnings over the last three months.
Are equity markets complacent, or fearful of the next crash?
After periods of strong equity gains such as we have seen the question is whether we are ‘due’ another crash. Many are worried about current valuation levels in the US and the potential impact of a Fed balance sheet reduction (as discussed recently by Nicolo Carpaneda at Bond Vigilantes). Others are concerned that we are ‘late cycle,’ an issue we have discussed previously.
There also seems to be some disagreement around sentiment: are investors complacent (talk of bubbles wasn’t limited to Bitcoin), or is this the most ‘unloved’ bull market in history? There are certainly signs, as Dave Fishwick discussed, that fear of volatility is being replaced by fear of missing out. I will discuss the nature of market sentiment in a blog later this week.
An encouraging macro backdrop…
For the moment it is hard to pick holes in the fundamental environment. The ‘synchronised global’ expansion narrative has intensified over the quarter, and is borne out by earnings growth.
One caveat here is that we are to some extent recovering from the effects of relatively broad weakness in the 2015/16. At that time we were sceptical of views that a global recession was imminent and the recovery now seems more broad-based than the corresponding decline. However base effects do seem to be playing at least some role in the degree of strength we are seeing today.
…and supportive policy…
US Two-year Treasury yields increased over the course of the quarter, consistent with the tightening path of the Fed. However, longer dated Treasuries have been more stable so far.
Investors seem yet to be convinced that a material tightening will be necessary, and this in part echoes the discussions of policy makers over the quarter. Alongside the ‘synchronised global growth’ narrative, another talking point which gained attention in Q3 was the ‘death of the Phillips curve’ i.e. why low unemployment is not prompting wage inflation. This is not just a US issue. In September, the UK reached the lowest rate of unemployment for 42 years
Though not a new argument, a speech last week by Janet Yellen and discussions at August’s Jackson Hole Symposium highlighted the issue (as Steven Andrew has discussed). Pressure for unexpected and aggressive tightening is not coming from inflation at present.
In spite of this, with yields at such low levels many developed market bond yields could nevertheless be vulnerable, as illustrated by relatively sharp yield increases in recent weeks. Other areas of the bond market, such as emerging market government bonds, selected areas of the credit market, and even Portuguese government bonds following the recent ratings upgrade, also offer less of a margin of safety than they once did.
Concerns for the period ahead
It is usually the risks that we can’t imagine today, rather than those which dominate the headlines, that can be most damaging to portfolios. That said, looking at areas that the consensus is worried about can be informative, particularly in observing how attention waxes and wanes over time and examining our own beliefs.
Chinese debt and growth, the reduction of Central Bank balance sheets, and US equity valuations seem to be the biggest fears among investors today. It is notable however that the former has taken a back seat in commentary in Q3, while the latter two have come to the fore.
This is not to say that China fears are about to emerge in the next quarter or even the next year, but being aware of how our own perceptions of risk shift can be informative. We can expect the attention paid to all three of these issues to change over time – what is critical for investors is that they do not allow themselves to be influenced simply by changes in price or what dominates the headlines. The temptation may be to feel more comfortable about life after a period such as last quarter, but risks are always present. It is the compensation we are being offered for those risks that matter.