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Winter market commentary: This time it’s different

Monthly commentary

How does the recent weakness in equity markets compare to events earlier this year? And what are the implications looking ahead?

2018: It started so well

At the turn of the year ‘Synchronised Growth’ was the phrase of the day, with the world’s economies moving ahead in unison for the first time since the Financial Crisis.  Markets reflected this, as shown below, with equities offering a near linear path of positive returns in 2017 and on into the start of this year.

2018: It started so well

And then we had the market weakness in February. This was the first sell off since 2008 sparked by the threat of inflation. This was suggested by stronger than expected US wage growth and employment data.  While it seemed like a surprise to equity investors, the bond market had signalled its concern for some time.  The yield on the 10 year US Treasury bond had risen markedly in the preceding months, pushing right up to the symbolically significant 3% level. However, as markets evaluated the sell off, the 10 year yield moderated, with investors questioning whether the US Federal Reserve would continue with monetary tightening.


But much of the violence in February came from the options market and from position covering, rather than wholesale negativity. As the dust settled, after what came to be seen as a technical event, buying continued.  The bounce from the fall was succeeded by a recovery. And then, with the obvious exception of the USA, markets began to track sideways through the summer.


Brexit has been a consistent cloud across the UK, elections in Europe provided uncertainty, but it was the threat of Trump’s trade wars and the direction of US monetary policy which weighed most heavily on momentum in the middle of this year.  Emerging markets were hit the hardest. Outside the US the positivity of early 2018 was noticeably absent. And now we come to the latest sell off.


Stormy weather

After sharp falls at the start of October, markets seem to have stabilised.  As the chart above highlights, equities appear to have found their floor.  But in contrast to February, there has been no V shaped bounce, with only Emerging Markets offering any signal that investors could immediately see hidden value.

And the interest story is subtly different too.  While the yield on the 10 year bond isn’t that much higher, it has now breached the 3% barrier (double the yield on UK Gilts).  There is continued rhetoric from the Federal Reserve about interest rate increases and self-evident Quantitative Tightening.  Equity investors can no longer support their optimism with the idea that rates will be “lower for longer”.


Source: November18

Confidence, ebbing


Source: OECD November18

At the start of the year confidence couldn’t have been higher.  The US economy was roaring, with this filtering through to the rest of the world.  Consumer confidence, business confidence, manufacturing PMI’s and credit conditions were positive and rising.  Come late summer, there has been an important change.  This is unsurprising given the political and monetary headwinds.  While the US is the sole central bank actively tightening, the 12 month rolling net purchases by global central banks are on a downward trajectory. This withdrawal of liquidity is likely to impact financial markets.

What are bonds saying?

Credit markets clearly reflect the tightening of monetary conditions and macro risks now present. At the turn of the year, credit spreads were at historical lows.  Since then they have reacted to the changing environment with a noticeable widening, breaking the medium term trend.  Once again this is a warning flag from the bond market that the risks to companies and the wider economy have moved on to a different paradigm. This chart compares yields on investment grade (left hand scale) with riskier, high yield bonds (right hand scale). Both have risen but the difference has widened considerably.


Source: PIMCO November18

Priced for perfection

Perhaps most telling indicator of a new paradigm is the sector rotation we have seen in US equities.  The market weakness in February was predicated on inflationary risks and the anticipation of interest rate increases which might be required to control prices. It is somewhat confusing that the Tech Sector was the sole positive contributor that month to the S&P500.  Theory implies that interest rate increases will hit growth stocks hardest given they are all about estimated future earnings. But Tech stocks shrugged it all off and the sector continued its meteoric climb.


Source: November18

Now, the momentum has waned.  While damaging events such as Facebook’s data breaches, Apple glitches and Tesla’s wayward CEO have contributed, it is clear that this time the sell off has been more ‘theoretical’.  There is a clear rotation, away from ‘growth’ and into the ‘value’ stocks. Utilities have risen 3% while the Tech Sector has seen falls in excess of 13%.  The chart below shows how ‘value’ has relatively outperformed in the recent downturn.


February’s sell off was violent and reminded investors that equities are not a one way bet, but the fundamentals had not yet changed significantly.  As we move closer to the year end, it appears conditions have changed and equity weakness in October and a lack of bounce in November seem to confirm this.  After a decade of central bank support and subdued market volatility the global economy is strong enough to allow ‘life support’ to be withdrawn.  Equity markets now appear to appreciate that this comes with a new set of challenges.



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