Well, that was an interesting 5 days! Here’s how the major asset classes performed during the week (on a total return basis).
The S&P 500 was the worst of the bunch, losing -4%. Developed international and emerging market stocks did a bit better, posting returns of -3.6% and -2.5%, respectively. Interestingly, while the S&P 500 briefly hit correction territory (down -10% from the highs) intraday, it closed just shy of that, down -9.3% since September 20th.
Technology stocks were hit particularly hard this week, causing the NASDAQ to close down -11.5% from its August 31st high.
What’s Behind the Volatility?
There are always a host of issues that combine to move markets one way or another, but in our mind there are three main factors behind the recent “correction.”
Rising Interest Rates
While this week actually brought about lower yields (the 10 year treasury closed the week down -10bps), 2018 has seen the 10 year go from 2.40 at the beginning of the year to a high of 3.23 just a couple weeks ago.
Rising rates aren’t all bad. If real yields (nominal yield minus inflation) are rising, that can be a positive sign that the economy is healthy and growing. As you can see below, this is exactly what’s happened year-to-date.
Rising yields can cause a sort of repricing of assets however, and there can be pain involved in that process. Alpine Macro summarized this dynamic recently:
“A sudden change in the interest rate structure in an economy always prompts a rapid repricing of assets and the process usually entails large moves in financial markets as investors try to find the new equilibrium.”
We’ve seen this movie before. Back in January of this year, yields spiked about 30bps and stocks sold off -10%.
After a few weeks of volatility (i.e. repricing), equities found their footing and recovered to find new highs. Granted stocks had the benefit of rising corporate earnings and the boost from the tax cut, but the rising yield dynamic was similar to today’s.
Growth in China has been slowing, and it remains a concern for global markets. Below is a chart of Chinese GDP growth going back 5 years.
Not only has the longer-term trend been downward sloping, the prior two quarters have accelerated the decline. What’s going on?
Here’s a take from Bank Credit Analyst:
“Real GDP increased at a weaker-than-expected pace in the third quarter. Industrial production surprised on the downside in September, echoing declines in the manufacturing PMI. Home sales are running well below housing starts, suggesting downside risk for the latter in the months ahead. Goldman’s China Current Activity Indicator has continued to grind lower, while the economic surprise index remains mired in negative territory.”
With the global economy so interconnected, a marked slowdown in China could certainly affect global growth.
Escalating Trade War
The slowdown in China has really been more of a domestic issue (exports have actually grown YTD). The trade war poses a different set of issues though. President Trump’s tariff’s on Chinese goods certainly won’t help the Chinese export sector, but the Chinese government’s willingness to let their currency fall may help soften the blow. This does not however, come without consequences.
The Yuan has fallen nearly -10% relative to the dollar since the Trump administration seriously floated the idea of tariffs on Chinese exports back in March. A weaker Yuan helps makes Chinese exports more competitive, but too steep a drop in the currency risks serious capital flight from the country – a dynamic that can pose serious long-term consequences.
Letting the Yuan depreciate is really the only major tool left for Chinese officials. They simply don’t import enough goods from the US to fight a tit-for-tat tariff battle. This is where the ripple effects can be felt in the rest of the world – a weaker Yuan means Chinese exports become more competitive, which in turn makes other economies less competitive. As is usually the case, the knock-on effects of trade wars stretch far beyond the key parties involved.
Trump and the communist party head of China, Xi Jinping, are meeting at the G20 summit at the end of November and both camps are optimistic some sort of compromise can be reached. While we wouldn’t hold our breath waiting for a grand resolution to the trade concerns, it’s certainly possible both countries could send a signal that gives some sort of reassurance to the market, however short-lived.
Healthy Correction or Beginning of Something Worse?
Does this correction mean we’re headed for a recession and/or a bear market? As we wrote last week recessions or major bear markets typically need economic data and corporate earnings to turn south before (in some cases well before) they hit. Just today, 3rd quarter GDP came in at a solid 3.5%, two tenths above expectations and while there was a weak new home sales number this week, leading economic indicators are broadly positive. The earnings picture also looks to be on solid ground. Consensus bottom-up estimates for 2019 show 9% growth in S&P 500 earnings, building on what is shaping up to be nearly 20% growth in 2018. These are far from bear market or recession levels.
This is our 6th correction of at least -10% since 2010, 8th if you round and count the two down turns of -9.8% and -9.9% in 2011 and 2012, respectively. And two of those have happened in 2018! Between these periods we seemed to get lulled to sleep by the lack of volatility and take for granted the fact that truly long-term investors are rewarded by capital markets. Times like these are a good reminder to revisit your investment principles, long-term goals, and true risk tolerance.
Whether or not this decline gets worse in the short-term is anyone’s guess but with a long enough time horizon, it too will be just another “correction.”
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