The main European equity market index was down 0.6% in August. At first sight it may seem that not much happened. Wrong. August was characterised by severe mean reversion. Arranging stocks by quintiles, based on the share price performance in August, shows clearly that there was a rush to close positions/book profits among investors. The best performing quintile in August (up 10.4% on average) was the worst performing in the previous 3 months (0% on average), whereas the worst performing quintile (down 8.8% on average) was the best performing in the previous 3 months (+8.4% on average).
Does the mean reversion that took place in August signal a potential change in the macroeconomic picture or in the outlook for financial markets? Recent data are backing our economic scenario (recovery in the US, Eurozone emerging slowly from recession, emerging markets suffering from a classical currency crisis), hence our bias towards consumer spending in developed markets and short cycle industrial companies. Of course, if poorly managed the Syrian issue could derail everything. However, there is nothing new in the fact that the Middle East can constantly derail anything almost at any time.
The real uncertainty comes from the potential impact of the Fed’s “tapering” attempts. Logically, they have to start moving otherwise they would lose all credibility (failing to act after having announced the need to do implement a change and with growing evidence of the strength of the US recovery). However, there is no need to do something drastic as inflation remains under control and Ben Bernanke is probably not inclined to bequeath his successor with a sudden reversal of monetary policy just a few months before his own departure. If this is the case, the impact on the economy should be limited. The uncertainty stems from the reaction of the bond market. Does it matter how long it will take to slow down, stop and then reverse QE, if the end result (higher yields) is an absolute certainty? The sharp rise in the US 10 year bond yield from 1.6% in May before Bernanke’s “tapering” talk to 2.9% 4 months later, just demonstrates that financial markets will quickly jump to the conclusion and start acting accordingly.
If bond markets “digest” in an orderly way the foregone conclusion that yields will continue to rise, equity markets should be safe. If there is stampede towards the exit door among the bond investing community, then equity markets will be rocked.