Much has been said in the past couple of years about the feasibility of having your cake and eating it. On markets, however, investors in recent years have become inured to the miraculous – until last week.
When the global economy is growing and unemployment is low, it is usually expected that interest rates will be set on an upward path that will – ultimately – arrest stock price growth. Yet for some time, even short-term investors have enjoyed a sweet spot of fortuitous circumstances: titanic quantities of money ($15 trillion) pumped into the market by central banks; negligible (but sufficient) inflation; and buoyant corporate earnings and global growth. As a result, money has been cheap to borrow, but stocks have offered strong – sometimes sensational – returns. In 2017, US inflation averaged just over 2%, the Fed funds rate only rose as far as 1.5%, volatility remained at historic lows – and the S&P 500 surged by 19%.
Last week, however, some investors were saying the miracle was finally over. The fireworks on markets had begun the previous Friday, but on Monday the S&P 500 underwent its biggest one-day dip since August 2011. The following day, the world followed suit, as leading indices in Europe and Asia saw rapid drops. Talk of a possible correction has been widespread in recent months, but the timing took investors by surprise. So, too, did its rapidity. The S&P 500 bucked and reared over the course of the week, as volatility persisted. The index ended the week down 4.4%, while the FTSE 100 fell by 4.7%, the Eurofirst 300 by 5.1% and the Nikkei 225 by 6.7%. While some investors were knocked off course by the sudden resurgence of volatility, more experienced stock-pickers know only too well that short-term volatility is far from abnormal on markets.
Behind the falls lay a rise in the yield on the 10-year US Treasury. It had risen rapidly after the release of payroll data that showed wage growth finally beginning to tick up meaningfully in the US, the same day that Janet Yellen ended her tenure as Chair of the Federal Reserve. The rise in yields reflects expectations that interest rates will rise more quickly than previously anticipated. If they do so, the relative appeal of equities might begin to fade for short-term investors, given the higher bond yields on offer.
The clearest gauge of last week’s freneticism is the VIX, which measures volatility on the S&P 500. Over the long term, the VIX has averaged 20 points – a score below 20 means volatility is subdued. In recent years, the VIX has generally sat at historic lows, highlighting the extraordinary calm that has characterised markets. In July last year, it struck a record low of 8.84 points. Last week, however, it struck an intraday peak of 50 before settling back into the low to mid 30s.
It is not entirely clear why it surged quite so far, but a couple of technical reasons have been proffered. For one, some investors in recent years have placed large bets on low volatility – last week those bets unwound in dramatic fashion. For another, it may have been exacerbated by algorithms and machines. JPMorgan Chase said last week that just 10% of trading is regular stock-picking, while the remainder is based on computer formulas. Some passive funds, for example, will sell off automatically when the market starts falling, adding momentum to an emerging pattern. Another argument is that a significant number of stocks were overvalued and, thus, all a correction really needed was a meaningful trigger. In such contexts, good active management comes into its own.
“Obviously buying a passive fund, you’re basically buying access to exposure to each of the stocks in the market,” said Nick Purves of RWC Partners, “and for obvious reasons, it’s often the most expensive stocks which have the biggest weighting in the market. So right now, when markets are high, you probably do need to be more selective in what you hold.”
In the real economy…
Meanwhile, there were plenty of reminders to be had that last week’s correction did not reflect a downturn in the world’s leading economy. The US service sector picked up momentum in January, according to the latest Purchasing Managers’ Index (PMI) survey by the Institute for Supply Management. It showed the PMI rose from 56 in December to 59.9 in January, where above 50 represents an increase.
Companies also offered plenty of positive indicators. Although energy stocks struggled through last week’s volatility, several of the leading names in both energy and mining announced impressive earnings results. Total boosted its dividend 10% on sharply rising earnings, Rio Tinto paid out the biggest dividend in its 145-year history as profits surged, and BP announced stellar results. Another indicator of the sector’s success came in UK tax receipts from the North Sea, which are forecast to reach £1 billion this year, up from zero in 2017. Although the oil price is far below its peak of a few years back, many investors argue that oil majors are now in a much strong position.
“The oil companies made the classic mistake, when oil was at $100, of thinking the good times would last forever and overdoing their capital expenditure,” says RWC’s Purves. “Too much supply then came onto the market, coupled with a small downturn in demand. The oil price collapsed and cashflows collapsed. But oil companies have now cut their operating costs and capital expenditure by about 50%. It’s amazing to think that oil companies today, with oil at $60 a barrel, will generate greater cashflow than they did with oil at $110 a barrel in 2013.”
Another UK focus in recent times has been Tesco, which has targeted the challenge posed by low-cost competitors. Nevertheless, concerns persist over digital disruption, and last week it emerged that it faces a gender pay gap lawsuit. The news won added attention because it coincided with the centenary of the parliamentary bill that gave (some) women the vote.
“Food retailers have been sold off on disruption fears, but too much,” said Chris Field of Majedie Asset Management. “Operationally, Tesco has dramatically changed to match Aldi and Lidl’s low-price, 3,000-product businesses. It has 28% market share and accounts for £1 of every £8 we spend.”
Majedie Asset Management and RWC Partners are fund managers for St. James’s Place.
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