Katz's Corner: October 2018 Review

TAMIM Joint Managing Director Darren Katz takes a look at the financial world in the month of October.

​October was a month where volatility reared its head with a vengeance. Markets globally ended the month in the red with very few exceptions, the MSCI World was down -6.8%, while the ASX 300 finished lower too, down almost -6.2%. What has been surprising has been the lack of catalysts, though certain valuations have been looking pricey, the fundamentals remain strong. The latest seasonally adjusted employment figures in Australia show that the economy added 32,800 jobs in October while the unemployment rate remained unchanged at 5%. Third quarter earnings in the US were off to a splendid start with the vast majority of companies beating EPS estimates.

We remain cautiously optimistic that the October equity sell-off is temporary and asymmetrical. The "correction" seems to have been largely led by a switch from high-growth to value. Markets are increasingly pricing in the one-off nature of the US tax cuts and the possibility of greater policy uncertainty. Issues ranging from trade, the end of monetary accommodation, Brexit and closer to home the state of the housing market create significant headwinds.

United States

US equities struggled through the month of October (and early into November) amid concerns over the durability and resilience of the economic cycle. However, the underlying economy remains on a stable footing and has been supported by strong consumer sentiment. Third quarter GDP was better than expected. The labour market continues to be tight and wage growth remains robust at 2.8% prompting the Federal Open Market Committee to note that there was “difficulty in finding qualified workers” raising inflation expectations.

On the earnings side, the third quarter on the whole exceeded consensus estimates with corporate earnings up 28% y/y. A significant portion of this was bolstered by the tax cuts and represents a cyclical high for earnings growth, we do not believe this to be the peak. US earnings are forecast to grow at 10% well into 2019, about 1% above the long-term rate.

The biggest surprises have been the tech giants, with Amazon and Alphabet reporting softer growth and seemingly giving credence to fears over their earnings strength. The month also saw a significant sell off in cyclically sensitive sectors including energy and industrials whilst defensive sectors held up relatively well. The large-cap indices also significantly outperformed the tech-heavy Nasdaq Composite with the slower-growing value stocks outperforming along with health care. Toward the end of October the midterms also offered some reprieve with investors welcoming the potential for gridlock.

We continue to be overall positive for US equities whilst being cognisant of signs of overheating and capacity constraints. The gradual tightening of the Fed balance sheet and the ballooning deficit continues to add upward pressure to rates and of course the trade war creates significant implications for both inflation ​and corporate margins, especially in industrials. 

Europe
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European Markets saw a sell-off  across the board during October, with the Stoxx 600 down close to -6%. Though markets seemed to have stabilised somewhat in recent months, concerns ranging from Italy’s growing rift with the EU, Brexit and continued signs of trade tensions were front of mind as investors grapple with the policy uncertainty. The recent Euro PMI data continued to add to the woes with the composite falling to 52.7 in October and the ECB still on track to end its net asset purchases by the end of calendar year adding cause for concern.

Italy continues to be the biggest worry with the deficit poised to breach the 3% budget deficit limit by 2020. The new Italian government’s spending measures make it increasingly likely that the European Commission will have to initiate the excessive deficit procedure (EDP), making the future increasingly uncertain for the Euro’s third largest economy. This has pushed the 10-year sovereign to above 3.4%. GDP data also confirmed soft growth pushing investor sentiment down even further. The weakest sectors were Materials and IT while Telecommunications offered some reprieve.

The UK proved to be a bright spot for Europe in October with economic data broadly positive. Wage growth grew at a record 3.1% and domestic inflation seemed to be firming. The UK stock market also outperformed global equities with the FTSE 100 holding up relatively well, retreating only -4.9%. More recently the political uncertainty around the newly released draft Brexit proposal meant that investors have increasingly sought a wait and see approach with the May government's position increasingly uncertain following a series of cabinet resignations.

Overall, Europe remains concerning primarily as a result of policy uncertainty and political gridlock. In addition, a disorderly Brexit would have severe implications for the UK in terms of the level of sterling, public finances and asset prices. Though the one significant upside seems to be that valuations look relatively cheap especially where it concerns financials.

Emerging Markets

Emerging markets continued their sell-off during October, underperforming the MSCI World. Mexico ​was the weakest index market as equities and the peso sold off sharply on rising concerns over the incoming government’s policies. Turkey had some much needed reprieve following signs that Washington and Ankara might be able to diffuse some of their tensions following the release of Pastor Brunson. The markets nevertheless remained in solidly sold-off territory with  the Lira continuing its downward trajectory.

In Asia, Korea was the weakest equity market, trade concerns being the primary driver (Korea being primarily an export-led economy). While in China the Shanghai Composite entered bear territory having fallen 20% from its peak in January. Companies in the technology and industrial sectors being the worst affected. 

Though several commentators insist that the sell-off in this instance was mostly driven by rising US interest rates and trade tensions, we tend to believe that the underperformance of mainland Chinese indices can be attributed to the government's push for deleveraging. The slowdown in Chinese GDP growth, while noteworthy, is not a substantial cause for concern at this stage. We remain convinced that underlying economic growth will continue, bolstered by government policies targeting a transition towards consumption led growth. The impact of higher tariffs also seem likely to be offset somewhat by a relative strength in the USD and strong domestic retail sales. Chinese consumption and the recalibration of supply chains in the region might also have flow-on effects in the medium-to long term through increased intra-regional trade further mitigating the impact of deteriorating trade conditions. Regulators have also made substantial moves to bolster market sentiment by supporting share buybacks and the PBoC has intervened by cutting the reserve requirement ratio yet again.

Conclusion

At the risk of boring you with repetition, our view has not changed. It is a significantly more volatile environment. Portfolios need to be liquid in their equity component and correctly diversified across asset classes. The volatility will create opportunity so this is the time to be cautious but not afraid.