This is a very jittery equity market, as evidenced by the magnitude of the day to day variations and the recent rise in the VIX and the VSTOXX indices (volatility implied by the US and European option markets respectively). Though, I would argue that in spite of their recent and strong rise, the absolute level reached by these indices fails to capture the full extent of the current level of anxiety among equity investors. Now, unlike during the “Great Rotation” (April/May), all sectors/styles/exchanges are susceptible to weakness.
All/most of the gains of this year have been wiped out (depending on which index you look at). Shall we blame the steadily deteriorating relations between Russia and the West, the latest flare up between Israel and Hamas, or the sweeping victories of ISIL?
Usually, the best gauge for geopolitical tensions is the price of oil, and it is at its lowest for the year and below the average of the last 4 years. So, we should look for a cause elsewhere. Shall we blame the underwhelming economic data coming out of the Euro zone? The data (0.4% CPI in July in EZ and very subdued level of activity) confirm our scenario that the Eurozone cannot deliver much in terms of growth.
The cure of competitive deflation imposed on the periphery (whose France is now a fully-fledged member) is dragging down the continent, and there is not much to offset this. Exports are being hit by the weakness of emerging markets and domestic demand in Germany which ought to be the counterbalancing factor to the efforts to improve competitiveness in the South, remains stuck in first gear. However, is it new news and why have the US and UK equity markets joined this correction whereas their respective economies are humming along nicely?
In my opinion, the current weakness has all to do with the prospect of an end to QE in the US. The Fed has signalled a vague timing for this event, and the macroeconomic data tend to encourage the view that QE will indeed come to an end sometimes next year. As QE has triggered a massive asset inflation, should not investors worry that ending it will mechanically produce the opposite effect?
Moreover, should not they be concerned also that at the time when some monetary policies will turn more restrictive in the US and the UK (a good year after many emerging economies) other will continue (Japan) or embark on a QE cruise of their own (ECB), creating further dislocations? These are all very valid reasons. However, one could have come up with the same analysis last year. Back then, everyone in equities saw the glass half full. Long bond yields had then taken notice of the Fed’s signalled change of tack (US 10 year moving from 1.6% at the lowest point to as high as 3%), but this had failed to deter equity investors who did not even blink at the constant and sharp deterioration in earnings estimates.
This time around, the bond market seems unperturbed (US 10 year is at 2.44% almost at the lowest for the year), and earnings estimates may be trending down, but this is the case most of the time anyway*and at least there will be this year a modicum of growth whereas it was a straight decline last year. However, equity investors are seeing the glass half empty.
This is the sort of phase in the cycle, when I am comforted by the fact that our Fund does never take a directional view on equity markets. With the continuing recovery in the US and UK and the very modest upturn in the Eurozone, we will have enough opportunities for a differential in real operational performances among companies, which is the foundation of investment policy. Discrimination based on fundamentals will return irrespective of the overall direction to be taken by asset prices.
* Goldman Sachs’s global equity strategist has recently produced of the best evidence of the ingrained over-optimism of sell side analysts, showing that since 1989, EPS estimates are revised down 60% of the time (“Strategy Matters”, May 29th 2014)