After a big week for financial markets, buckle up, the rollercoaster ride has only just started for investors.
After a big week for financial markets, buckle up, the rollercoaster ride has only just started for investors.
Much of the consternation reflects the pressure in three major parts of the financial system: US bond yields, oil prices and China’s currency, the renminbi. What links them are the policy stances of the Trump administration regarding the US economy, Iran and China.
The 10-year Treasury yield wields huge influence over valuations for global financial assets and has risen to its highest level in seven years, reflecting an economy that is running hotter than previously thought. The flipside of all that fiscal stimulus is higher interest rates from the Fed, a prospect that deeply upsets President Trump and which has rattled Wall Street this week.
The prospect of US sanctions being applied on Iran next month has helped propel Brent crude prices beyond $80 a barrel (a year ago they were at $56) as a supply squeeze beckons. Higher oil prices are a tax that fleeces the pockets of consumers and companies, particularly in countries whose local currencies has tumbled versus the greenback this year.
For all the pain that a strong dollar and higher oil prices have wrought across emerging markets, that stress will enter a whole new world of intensity should China decide to allow the renminbi to depreciate beyond 7Rmb, a level previously visited during 2008.
While much of this week’s ructions have been in stocks, it’s the trio of Treasuries, oil and the renminbi that have the power to influence asset allocation decisions in coming weeks and resonate well beyond. Let’s start with long-dated Treasury bond yields and signs of a disturbing breakdown in their relationship with share prices.
Wall Street’s bull run has been led by tech stocks, whose lofty valuations have partly reflected low interest rates and expectations that the economy, like a struggling cyclist, simply can’t sustain a higher gear. Events so far in October have challenged that assumption, and critically, higher yields reflect expectations for a stronger economy rather than rising inflation. There’s some good news in that, but also suggests we are in a new and higher range for long-dated bond yields.
This is where things start looking tough for US equities, which have long enjoyed the backdrop of low yields that have polished the value of future cash flows and nourished the market bull. When the S&P 500 hit its most recent peak in September, investors enjoyed a total return of 11.2 per cent for 2018. This week that performance shrivelled to below 4 per cent.
The bigger concern is whether the bond market’s usual relationship with equities is shifting. Falling equity prices usually prompt a rally in bond prices that helps offset losses within a portfolio split between stocks and fixed income. So far this year the total return from owning long-dated Treasuries is minus 7.6 per cent. For a portfolio containing a mix of equities and bonds, 2018 is looking a little shaky.
That equity market corrections are messy affairs isn’t helpful. This matters as we are not far from year end. Recall, after dropping 10 per cent into February, the S&P 500 only resumed its upward path in early April. Higher rates that can run for a few months and oil will weigh on the US economy and, along with a tight jobs market, pressure the bottom line for companies.
Seeking alternatives beyond the US may not help much. As Wall Street stumbled this week, so did global markets. What is so interesting here is that global equities peaked in January. Europe’s Stoxx 600 index closed at a new low for the year while the FTSE 100 settled below 7,000 for the first time since March. The need for greater fiscal stimulus in the UK, Europe and China to get the global economy out of the slow lane is clear.
A slowing China — foreign carmakers say the market for vehicle sales has stalled after a three-decade run — and tightening oil prices are major headwinds. For the eurozone, an acceleration in Chinese activity matters a great deal more than the US firing on all cylinders.
Now we should see a bounce in China emerge early next year, as the stimulative effect of a sliding renminbi and recent monetary easing takes effect.
That’s one reason why investors shouldn’t expect a currency shock from Beijing, although a weaker renminbi is a risk as the Trump administration pushes hard on trade, intellectual property and a range of issues that some have dubbed the new cold war between these two powers.
Long-term investors will probably stick to their current strategies and ride out this latest market tempest, but we are approaching dangerous territory.
The evidence leans towards the view that a moderating US economy in 2019 is balanced by a rebound in China. That opens the door to a stronger rotation among asset classes and new opportunities for investors. But that’s some way off, and before we get there, expect a bumpy ride.
