So far this month October is living up to its reputation and history as one of the most volatile months of the year. Market and investor sentiment has turned rather bearish this month (market sentiment is the overall attitude of investors on a particular market). It’s a good contrarian indicator of the fear embedded in the market – usually when the bearish (fear) sentiment is highest; it’s a good time to buy (Figure 1).
Figure 1: US Market Sentiment Bearish Index – At the beginning of the year, market fears were low as markets were high. Today investors have become bearish on the market.
Many investors believe a global recession is on the horizon. So, we ask ourselves how probable is this and what does that mean for our portfolios?
Our investment philosophy tenet of Seeking the Truth keeps us disciplined in looking deeper into the market, focusing on and making sense of the data, and understanding the ‘why’. Let’s first discuss the ‘why’ – what is causing global market fears?
The Cause: What's he Fear?
Policy Mistake by the US Federal Reserve
We believe the biggest reason for the recent sell-off is the increased risk of the US Fed raising interest rates too quickly, and choking off GDP growth and curtailing the business cycle. This is the biggest tail risk for the market. The fear stems from the fact that the US Fed appears to want to tighten policy above the neutral US Fed Funds rate and ignore the facts of their own balance sheet normalization, i.e. they sell government bonds every month, tightening liquidity. We have seen this manifest itself in GDP estimates coming down to 3.6% in 2019 from 3.8% in 2018. Financial conditions are tightening – US financial conditions have tightened by 46bps according to Goldman Sachs. This along with the equity sell off can cause GDP to contract feeding the narrative.
Despite companies beating their earnings forecast in Q3, there was a lackluster reaction, and for the even smallest of misses, there has been performance downside punishment. Forward earnings guidance has been poor, stemming from macro uncertainty, cost input pressures from higher labor costs, commodity costs, freight costs and foreign exchange headwinds (i.e. US dollar appreciating), and uncertainty over the full impact of US trade tariffs.
Trade War Continues
President Trump has been quoted that he has no intention to ease up on China and China says it does not fear a trade war - lots of grandstanding. China fine tuning their economy has not been seen as enough by investors. Despite lowering interest rates, cutting income tax, increased fiscal spending, increased support for the private sector, cutting export taxes, increased support for the stock market, etc., these measures are still seen as not enough to offset the slowdown and the deleveraging in their economy from the potential trade war.
Italian Budget Showdown
Friction between Italy and the EU reaches a crescendo with the budget not accepted by the EU and sent back to Italy. Investors are becoming concerned that economic sanctions will be applied to the Italian economy by the EU. In addition, a systemic tail risk event for Italy is a fear as Italian bond yields over German government bond yields exceed 3%, and spreads have widened out.
Saudi Arabia killing dissident journalist, US Navy sailing in the South China Sea and today explosive pipe bombs being sent to high level Democrats, President Obama and Hilary Clinton, and critics of President Trump.
First, despite the uncertainty and investor fear, we do not believe a global recession is imminent. Below are a few data points on why:
1. Strength in Purchasing Managers’ Index (PMI). PMI is a barometer of future economic activity, anything above 50 signifies growth. Overall, PMIs have been slowing from high levels; however remain firmly above 50, which signifies they continue to be in expansionary territory. As seen by Figure 2, global PMIs are positive, signaling positive global economic growth.
Figure 2: Global all-industry PMI and GDP - PMI (on the left) is above 50, signifying expansionary territory, whereas GDP (on the right) remains positive.
Source: JP Morgan, Markit, national sources
2. Earnings Growth Continues. We are seeing earnings growth, however, the market is underappreciating this. For example, the S&P 500 had 48% of companies report Q3 earnings as of today. Earnings per share (EPS) growth is up 22.5% for the same period last year, revenue growth is 7.6%, and 77% of companies have beaten consensus EPS estimates. As mentioned above, despite beating earnings there was a lacklustre reaction from the market. Earnings growth is sure to slow from these high levels, but to slow to recessionary levels seems improbable.
3. Low Probability of Recession. While recessionary risk has risen, it is far from levels which signal that a recession is forth coming in the foreseeable future. Figure 3 shows that the probability of a recession in the next 12 months, based on near-term indicators, has moved from 5% to 18%. While this is trending higher, it is far from the 50% threshold that can lead to a recession.
Figure 3: One-Year Recession Probabilities Since 1955.
Source: Various government and non-government sources, JP Morgan
This leads us to…where do we go from here?
The Effect - Where Do We Go From Here?
Some investors believe now is the time to go into cash and sit on the sidelines through this turbulence. The adage “buy low, sell high” is a common phrase that everyone wants to execute on. The ability to execute is highly difficult due to human nature’s discomfort and reaction when we encounter fear and the unknown. However, for patient, long-term investors who focus on the fundamental data rather than the noise, when fear is high usually it’s “time to buy”. Figure 4 shows the US Market Sentiment Bearish Index going back to January 2017. We focus on the high fear point (or most bearish sentiment) in March 2017 to end of the year (December 2017).
Figure 4: US Market Sentiment Bearish Index since January 2017.
For those investors who were able to execute on ‘buying when the market was fearful or bearish’, the S&P 500 returned 13% (Figure 5).
Figure 5: S&P 500 Index Performance from March 2017 (fear peak in 2017) to December 31, 2017.
Threat or fear should not drive investment decisions, and this environment is providing opportunities at a stock specific level. Our portfolios are tilted towards a growth economy; therefore, in the short term, the effect is that we are down more than the index. We are overweight in areas of the market that people fear the most, such as consumer discretionary and industrials, and underweight sectors that others flee to in a fear-driven environment, such as healthcare and consumer staples. Our second investment philosophy tenet of Being Different means ‘you can’t take the same actions as everyone else and expect to outperform'. Active share is an indicator of how different a portfolio is from the benchmark. Looking at the CWB M&P portfolios, all have exceedingly high active share indicating large deviation from the index. Figure 6 gives a look through on each of our investment strategies and how they compare to the benchmark from a fundamental and valuation perspective. In summary, our stock portfolio valuations are cheaper than the benchmark, with stronger balance sheets, and with a higher degree of active share (which means no closet indexing here!).
Figure 6: Valuation and Fundamental Characteristics of Our Portfolios
When emotions and discomfort seeps in, we fall back on our philosophy of how we invest. Our purpose is to find investments where we believe there are inefficiencies we can exploit. Inevitably, this leads us to areas of the market that are less traveled and further away from the index. By doing so we understand that investment return will deviate from that of the benchmark, both to the upside and the downside.
Our mission is to focus on the destination, not on the bumps in the road. This sell-off ultimately is a bump in the road that we will take advantage of and steer our clients through.