October equity rout – higher interest rates not the sole culprit

12 Oct 2018

Key takeaways:

  • US interest rates have moved notably higher on the back of strong data and Federal Reserve communications that have been perceived as hawkish.
  • The increase in rates prompted the initial decline in US equities, but sector analysis suggests that other factors have contributed as well.
  • Highly valued technology stocks were vulnerable to rising rates but also doubts about the earnings outlook, particularly the threat from rising trade tensions
  • Investors are now taking advantage of the opportunity to rotate into different styles, and sell winners that had become very expensive.

US interest rates have been driven higher recently by strong economic data and Federal Reserve communications, perceived as hawkish:

Exhibit 1: US 10-year interest rates break above the 3% level (change in yield of 10-year US Treasury bond, 01/10/17 to 12/10/18)

Source: Bloomberg, BNP Paribas Asset Management, data as at 12/10/2018

As a result the first 11 days of  October has proven to be a challenging month for global equities. The S&P 500 index has declined about seven percent from its September 20 peak, while the MSCI World ex-USA index has declined by over five percent over the same period.

Exhibit 2: A difficult start to October for the S&P 500 index (changes in the valuation of the S&P 500 index, 01/10/17 to 12/10/18)

Source: Bloomberg, BNP Paribas Asset Management, data as at 12/10/2018

While other factors have been at play, the initial catalyst for the selloff has been the rise in Treasury yields, with the 10-year Treasury yield breaking above its May high for the year.

Shifting expectations for monetary policy are making themselves felt

The rise in risk-free rates appears to have its roots in shifting expectations for monetary policy. While economic data have been mixed over recent weeks, strong employment and wage numbers combined with encouraging survey readings on service sector activity have led investors to discount a steeper path for policy rates over the next two years. Indeed, by the end of last week, forward OIS rates reflected a higher terminal rate for this cycle than at any other point since the Federal Open Market Committee began raising rates in 2015.

Chairman Powell – extraordinarily positive on the  US economic outlook

Communications from Chairman Powell also likely contributed to higher anticipated policy rates and the rise in Treasury yields. At his post-meeting press briefing two weeks ago and in subsequent remarks, Powell has been extraordinarily positive on the economic outlook, projecting confidence even as the trade dispute with China has escalated meaningfully. He has also recently commented that the stance of policy remains “a long way from neutral” and may ultimately need to move into restrictive territory.

These comments should not have been surprising to investors, especially as they align with the Committee’s economic and interest rate projections. But they represent a change in thrust from the Chair, who had previously focused only on the need to normalize policy gradually over time, staying away from sharing his own view on whether policy would eventually turn restrictive.

Tech stocks – so the mighty fall…

Still, we find the explanation that higher policy rates are the only driver of the fall in equity prices to be overly simplistic, especially given that the policy stance in the US will remain accommodative well into next year.

The US “technology plus” sector (IT plus Internet & Direct Marketing Retail, normally part of the Consumer Discretionary sector) accounted for 2.4 % points out of the recent 5.0 % decline in the MSCI USA index. In other words, technology contributed over 50% to the fall in the index (see exhibit 3).

Exhibit 3: Contribution to MSCI index return by sector (total return from period 20/09/2018 to 10/10/2018)

Note: EGY = Energy, MAT = Materials, IND = Industrials, CD- = Consumer Discretionary excluding Internet & Direct Marketing Retail, C-S = Consumer Staples, HLT = Health Care, FIN = Financials, IT+ = Information Technology including Internet & Direct Marketing Retail, TEL = Telecommunication Services, UTY = Utilities, RST = Real Estate. Source: MSCI, FactSet, BNP Paribas Asset Management, data as at 10/10/2018.

Exclude the sector and the return was just -3.1%, similar to the 2.7% decline for the equivalent sectors of the MSCI World ex-USA index. Technology is not considered an interest-rate sensitive sector, and those sectors that are, notably utilities and real estate, performed relatively well, which again suggests it was not merely interest rates that were behind the sell-off. Another indicator that the technology sector was still a key weak point is that in emerging markets, it was the MSCI China technology index that also saw the biggest declines.

An abrupt awakening to the risks of tariffs?

This explanation raises the question, however, if rising interest rates were not the only culprit, why did technology suddenly decline? The ever-rising trade tensions with China seem to be a key cause, especially after what had seemed a too complacent reaction from the market to the announcement by the Trump administration of 10% tariffs on USD 200 billion of Chinese imports last month.

Perhaps investors have finally started to appreciate the risk to corporate profits from the disruption to supply chains, increased import costs, and squeezed margins. Valuations in the sector have long been high, but they appeared justified as long as earnings growth lived up to expectations. With forecasts for the sector well outpacing the rest of the market, stocks were clearly vulnerable to a correction once the forecasts were called into doubt (see exhibit 4).

Exhibit 4: Next-twelve-month earnings (EBITDA) revisions

Note: Tech+ includes Internet & Direct Marketing Retail. Source: FactSet, BNP Paribas Asset Management, data as at 10/10/2018.

Slowing of growth in China is a concern

Beyond the impact (both real and perceived) of looming trade wars, we have recently seen signs of weakness in automotive and industrial end markets. Many semiconductor and technology component stocks have significant exposure to this sector. Finally, investors may have simply become more cautious, as doubts persist about the ability of the Chinese government to offset not only the slowdown in the economy caused by their own deleveraging efforts, but by the impact of US tariffs. The latest China manufacturing PMIs are nearing 50 (the threshold between expansion and contraction) and are close to the lowest levels they’ve reached over the last two years.

A warning as to where trade wars and normalisation of monetary policy might lead…

We nonetheless believe that IT spending intentions are still fairly strong, and the weakness in semiconductors is at least partly driven by shortages or are limited to computer memory. Moreover, even with the declines in the market, returns year-to-date remain quite good. The MSCI USA Internet Software & Services index is still up 21% through 10 October and the Information Technology index is up 11%. The fall for the broader technology index is commensurate with drops we saw earlier this year, and in both those instances the index subsequently made new highs.

In addition, now that a sell-off has begun, investors are taking advantage of the opportunity to rotate style and to sell winners, especially those that had become very expensive.

What is the outlook from here? On one hand, the US economic expansion is still robust, and corporate fundamentals remain strong, but recent market movements highlight the risk not only from trade wars, but also from what could come next if interest rates rise further.