Global market sell-off has shaken investors out of their complacency – and that’s a good thing
- Nicholas Spiro says debate over the causes of the severe deterioration has been fierce. Whatever the reasons, the return of volatility has been useful in ridding markets of complacency, arguably the biggest risk in recent years
What a difference a month can make.
On September 20, the benchmark S&P 500 equity index hit a record high, closing just 70 points below the lofty level of 3,000. Yet by the time markets closed last Friday, the index had lost 9.3 per cent, putting it on track for its worst monthly performance since February 2009.
In a sign of the abruptness and severity of the sell-off, two of the five worst trading sessions for the S&P 500 since 2015 have occurred in the last fortnight, according to data from Bloomberg. Global stocks, moreover, which have lost 9.4 per cent in October, are on course for their worst month since the height of the euro zone crisis in mid-2012.
Yet it is the sharp deterioration in sentiment in America’s once-resilient stock market – the S&P 500 has swung from an all-time high to being on the verge of entering correction territory in the space of just five weeks – that has stunned international investors and sparked a fierce debate over the precise causes of this month’s sell-off.
Is it the fears about China’s slowing economy, exacerbated by the continuation of the trade war, which have shone a spotlight on the acute tensions between Beijing’s deleveraging campaign and efforts to shore up growth and stem the rout in mainland stocks? Signs that capital outflows are picking up – net purchases of foreign currency by Chinese banks’ clients have risen to their highest level since 2016, according to Bloomberg, adding to the strain on the yuan – increase the risk of a 2015-type crisis. What is more, all the spikes in volatility in Chinese equities over the past several years have been accompanied by sharp falls in global stocks.
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Or could it be mounting concerns that US corporate earnings – the underpinning of the high valuations and strong performance of American stocks in the first three quarters of this year – have peaked due to increased pressure on profit margins? The announcement last week of weaker-than-expected third-quarter results from several leading US industrial companies and, more worryingly, the steep decline in the shares of popular technology firms – the fuel for this year’s rally in American equities – are stoking fears that the nine-year-old bull market has run its course.
A third explanation for the sell-off is this year’s tightening in financial conditions stemming mainly from the hawkish policy stance of the Federal Reserve. The most interest rate-sensitive parts of the US stock market, in particular home-builders and banks, have fared badly, while defensive sectors, such as utilities, have performed better.
The Fed, moreover, is showing no signs of becoming less hawkish, suggesting equities would have to fall much further before the central bank halts its rate-hiking cycle. Tim Duy, a prominent Fed-watcher at the University of Oregon, claims “Fed policy is to keep hiking until something breaks”.
Other factors that have contributed to October’s carnage in stock markets include the sharp sell-off in Italian government debt and growing pressure on the closely watched corporate bond market.
Yet while pressure points in markets are clearly increasing, all of the vulnerabilities mentioned above were apparent months ago or were flagged by investment strategists as risks that were likely to become more pronounced in the coming months. Moreover, none of them provide a compelling reason why sentiment deteriorated so rapidly in the last few weeks.
If China is to blame, then why have emerging market currencies – including the yuan itself – stabilised since hitting a low in mid-September and even shown gains since then, according to the MSCI Emerging Markets Currency Index? Similarly, if US corporate earnings are the culprit, then why are investors fretting when more than 70 per cent of companies’ third-quarter results have beaten analysts’ expectations?
A more convincing explanation for this month’s fierce selling pressure is that it comes after a period of remarkable calm, adding to the sense of panic gripping markets. Last year, the S&P 500 recorded a gain every single month. As recently as January, the index enjoyed one of its strongest monthly performances since the 2008 financial crisis.
After an unusually long stretch of ultra-low volatility and high returns, investors must now contend with turbulent conditions that are more in line with historical trends. The realisation that the era of ultra-loose monetary policy is drawing to a close is fuelling the current anxiety in markets. As JPMorgan noted in a report published last Friday, “if complacency is one of the words most associated with the pre-[crisis] years … then paranoia may be the one most tied to what remains of this cycle”.
Still, it is worth noting that this month’s plunge in the S&P 500 is not as severe as some earlier pullbacks, notably the China-induced panic in January 2016 when the index lost 11 per cent in just 15 trading sessions. Yet, back then, the Fed was still quite dovish, and there was no trade war to dampen sentiment.
While the selling pressure in global stocks could persist for some time yet, at least investors can no longer be accused of complacency, arguably the biggest risk in markets over the past several years.
Nicholas Spiro is a partner at Lauressa Advisory