US central bank comments
As the US Federal Reserve (the Fed) gradually normalises monetary policy by following a path of planned rate rises and reducing the size of its balance sheet, liquidity (the speed at which you can buy and sell assets on the market) is tightening. We should therefore expect patches of heightened market volatility. Looking back over 2018 so far, in February, we saw a sharp market reaction to US wage growth figures, and in August the market dip was catalysed initially by very small sanctions against Turkey. The spark for markets this time was Fed Chair Jerome Powell’s comment on 3rd October that the Fed was still a ‘long way from neutral’.
The Federal Open Markets Committee’s (FOMC) forecasts point to around four more rate hikes over this economic cycle. After the release of the FOMC’s September ‘dot plot’, it was clear was that market expectations were behind those of the Fed, which left room for the market implied rates to adjust (to match the FOMC’s forecasts), and the market’s reaction has been surprisingly sharp. The US 10-year treasury is now trading at a yield of around 3.16%, which is broadly in line with the FOMC’s long-run rate expectations; this should provide treasuries with some support.
Growth versus value
The technology sector has been hit particularly hard over the last few days. The price of an equity is essentially its future earnings, adjusted by investors (using a discount rate) to compensate for uncertainty. The discount rate used is traditionally the US 10-year treasury yield, and as this has risen, future earnings appear less attractive. ‘Growth’ sectors, such as technology, trade at a premium to the overall market as they are expected to have significant levels of earnings further down the line. ‘Value’ sectors, such as US financials, which are already producing reasonable earnings, are less sensitive to changes in the discount rate. Since the start of October, the MSCI World Information Technology sector has fallen over 8% whilst the World Financials index has fallen by just over 2%.
The US CPI inflation release on Thursday came in below the market’s expectations, which should help stabilise sentiment and relieve the pressure on the Federal Reserve to increase the pace of rate hikes. Nevertheless, US equity markets have continued to slide despite this announcement, which suggests to us that the current sell-off is not purely linked to rates.
The similarities between February’s sell-off and this current bout of volatility are clear, as concerns over bond yields were the catalyst for a sharp spike in volatility in both cases. When the post-mortem of February’s declines was complete, many pointed to complex derivatives which traded based on volatility levels. When volatility increased sharply in February, traders who were betting that volatility would remain subdued ultimately needed to sell the stock market, which caused an indiscriminate sell-off. This time, while there may be an element of this, one of the key products that fuelled the February problem has now been closed, and many of the other products are far smaller parts of the market than they once were. That said, volatility trading and systematic trading remain a major part of the market, and are probably exacerbating market movements.
We are now at the beginning of the US Q3 earnings season, with expectations of around 19% year-on-year growth for the overall market. Should US companies continue to outperform these high estimates, this may be enough to distract investors from bond yields and make them focus on fundamentals. JP Morgan, Citi and Wells Fargo all report early, so we will have a preview from the banking sector before the bulk of earnings are reported in a couple of weeks’ time.
The Fed may speak out and moderate Powell’s comments. The market’s expectations are still quite far behind that of the US central bank; although Powell or another governor may look to calm markets, although this is not our base case.
Even with the recent sell-off in US equity markets, indices have only retrenched to levels seen at the start of July. While equity corrections are painful, the fundamentals of the US market remain strong:
1. The US ISM surveys are at their highest levels in its 21-year history
2. US unemployment is at its lowest level since 1969
3. GDP growth remains above trend, with inventories at near-historic lows, suggesting that GDP growth has been fundamentally strong rather than indicative of ‘restocking’
4. Inflation and expectations remain under control, suggesting (given the still solid growth outlook) a predictable path of rate hikes by the Fed rather than a sudden escalation
5. Earnings growth is very likely to be over 20% for 2018, with potential for gains if Q3 and Q4 earnings outperform
6. Valuation multiples are now at attractive levels of 15.7x the next 12 months of earnings, which compares favourably to historical valuation levels
Impact on the IFSL Brunsdon Investment Funds
Both the IFSL Brunsdon Adventurous Growth Fund and the IFSL Brunsdon Cautious Growth Fund have been impacted by the market decline (by 6.3% and 2.1%, respectively since the start of October) with the IFSL Brunsdon Adventurous Growth Fund slightly behind the IA Flexible sector and the IFSL Brunsdon Cautious Growth Fund’s fall broadly in line with movements of the IA Mixed Investment 0-35% sector. This portfolio does have a degree of exposure to equity markets, so when stocks come under pressure it is unlikely to be immune; the equity positions were the primary cause of the portfolio’s fall. Bond positions generally held up much better and it was good to see that those positions the portfolio provided some protection from difficult markets, as they fell by much less than equities. To some degree, this mirrors what we saw in February.
The IFSL Brunsdon Adventurous Growth Fund has been affected to a greater extent, due to its much higher exposure to equities. The Fund is down over the month to date and behind the IA Flexible sector. None of the broad equity sectors within the portfolio have been immune to the market decline, and the main detractors have been elements of the portfolio that had been top drivers of returns up until October, namely technology and smaller companies. Standard Life Global Smaller Companies, Scottish Mortgage and Polar Capital Global Technology are all down in excess of 11% over the month, whilst US, European and Japanese smaller companies are all down nearly 10%. Momentum-based funds such as the Meridian UK Smaller Companies Focus have also been hit quite hard, but we have seen much better performance from positions in ‘value’ funds, such as Aberforth Smaller Companies, JO Hambro UK Equity Income, and GLG Undervalued.
In terms of portfolio outlook, we remain broadly happy with the positioning of both the IFSL Brunsdon Adventurous and IFSL Brunsdon Cautious Growth Funds. We feel that this recent market volatility is a temporary blip, and that economic data from the US remains solid. The expectations are for a solid set of Q3 earnings results and, assuming this turns out to be correct, that investors will re-focus on the fundamentals. Nevertheless, we think we are now in an environment where we could expect more instances of short, sharp market pull-backs and we acknowledge that some of the positions that have served the portfolio well may be more at risk in these scenarios. We also feel that we are heading towards the end of the current market cycle and whilst we remain positive over the prospects for equities in the near term, we need to be aware of the potential additional risks posed by this stage of the market cycle.
IFSL Brunsdon Adventurous Growth Fund
IFSL Brunsdon Adventurous Growth Fund
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