The summer felt quite volatile, with lots of headlines about trade agreements, elections and the like, as well as some big price moves in Turkey, Argentina, and Italy.
However, not much really changed. Even the specific issues above were largely what we were writing about three months ago and the key themes of the day were still in place:
- Global economic data has for the most part been expansionary but slowing. This has been the case for much of the year and is clearly troubling investors. As the synchronised expansion of 2017 has given way, thoughts turn to looking for the next downturn.
- At the same time, rising US cash rates have been treated as a cyclical domestic economy issue. They have not been viewed as a sustained shift in the longer-term discount rate underpinning all assets. This is why we have seen a flattening of the US yield curve.
It also explains why we have had limited pressure on global equity markets. We’ve written frequently about the importance of rate pressures (or ‘valuation risk’) for all assets, but in Q3 growth concerns were the main issue (China, trade wars, and the like). Against this background there was diversification in equity performance:
And while much was made out of US Dollar strength versus emerging markets, the market was largely discerning: punishing Turkey and Argentina, but with strong gains out of Mexico.
However, while Q3 looked like more of the same, there have already been some more interesting signs of shifting behaviour in the first week of Q4.
The role of rates
Over the last three years, equity markets have de-rated (got ‘cheaper’) either due to fears about growth, as was the case in the first half of 2016, or due to a broader reassessment of discount rates. Since the financial crisis we have been used to equities ‘cheapening up’ (usually with prices falling) in response to the former (growth fears).
However, there are signs that potential pressure from interest rates are becoming more significant. This ‘valuation risk’ appeared to be in evidence in February this year, as evidenced by a steepening in the yield curve (as we wrote at the time).
The different sources of de-rating can be seen in figure 2 below, which shows a measure of equity valuation (the forward earnings yield, a higher level implies ‘cheaper’ valuations) alongside a measure of US curve steepness (right hand axis, a rising line indicates a steepening). For equities, I have used the FTSE World ex-US index to show that the de-rating this year was not just a result of US tax cuts.
In Q3, it was a return of worries about growth that drove the de-rating of equities.
Are we already seeing a change of dynamic in Q4?
As I write, the above characterisation of market behaviour already shows signs of shifting. There have been material moves at the long end of the curve which have taken US 30-Year Treasuries to yields not seen since 2014, though the shift in the curve itself is relatively modest.
This appears to be weighing more significantly on equity markets. It also creates confusion for investors who are concerned that we could be facing a ‘double whammy’: rising rates in the US and slowing growth elsewhere (this is why it could be becoming comfortable to see the US as ‘the only game in town’).
Richard Woolnough wrote last week about the important role played by US long rates, and whether we may be about to see a turning point towards a path of higher rates. The health of the US economy plays an important role here, as does the path of wage inflation.
Another important consideration could be what happens to the diversification properties offered by these bonds. We have written about this extensively in terms of cross asset correlation, but another point worth considering is the role of cash today.
For much of the last decade US cash has offered deeply unattractive returns. In that period, if investors were in need of safety, US long dated Treasuries offered a far more appealing proposition. Today the opportunity cost involved with holding cash for safety instead of long duration bonds is greatly reduced:
There are clear reasons why multi asset investors may look to long duration assets so that they can get ‘bang for their buck’ when seeking short term price diversification. But with the risk properties of Treasuries less certain today, the belief that long dated Treasuries can play this role could come under threat.
We seem to be far from such a significant change in risk perceptions but, were we to see a more meaningful move in the direction that we have seen in the last couple of weeks then Q4 could represent a more significant break with previous months than was the case in Q3.