October has emerged—thus far—as a tumultuous time for investors. While market gains have been pared this month, Bank of America, U.S. Trust believes it’s too early to call an end to the equity bull market.
In a new report, Joe Quinlan, Head of CIO Market Strategy, explains why the beast is still kicking. He discusses what triggered the recent sell-off, why the wall of worry is surmountable and six key market convictions.
The Bull is Still Kicking
October has emerged—thus far—as a tumultuous time for investors. The sell-off last week, with the S&P 500 dropping 5.3% in a two-day stretch, has triggered fears (and obituaries) about the U.S. equity bull market. The latter commenced on March 9, 2009, and has handed investors total returns of 400% through October 12. While market gains have been pared this month, we believe it’s too early to call an end to the bull market. This beast is still kicking.
The recent sell-off was triggered by not one but multiple dynamics, notably the backup in U.S. interest rates and the speed with which the rise in yields occurred; elevated oil prices; a hawkish Fed; mounting signs of U.S. inflationary pressures; U.S.-China trade tensions; and Italian credit risks. Technical factors were also at play, with portfolio de-risking in long-favored growth plays (aka technology) adding to selling pressures and to the sharp rotational pullback from high momentum and high-valued segments of the equity market.
All of the above represents a massive wall of worry for investors but one, we believe, that is surmountable given prevailing economic/earnings fundamentals in the United States and, to a lesser degree, overseas. At home, the backup in interest rates reflects a U.S. economy that has convincingly broken free from the “secular stagnation” narrative of the past few years. Outside a widening trade gap, the economy is firing on all cylinders, powered by elevated consumer confidence and spending levels, robust capital expenditure levels, corporate tax reform and fiscal spending. The U.S. unemployment rate is at a 49-year low, while inflation hovers, remarkably, around 2%, or close to the Fed’s target level.
Over the balance of this year, the global economic backdrop has shifted from one of synchronized global growth to a desynchronized expansion, led unequivocally by the United States. While the rest of the world has slowed over the past six months, China included, the U.S. has powered ahead. Real growth remains modest but firm in the two largest economies excluding the U.S.—China and the European Union—but it’s the U.S. acting as the world’s locomotive. Given all of the above, U.S. monetary policy is becoming less stimulative—a fact that should hardly be surprising to the markets. As previously noted, by the head of CIO Macro Strategy “interest rates are moving into a more normal range consistent with a much healthier U.S. economy.”
The normalization of rates, however, has raised market fears that the Fed will overshoot and move too aggressively and that the “Fed put” is fading. That said, remember, while the markets are relatively well braced for higher rates, it’s the speed with which rates rise that can notably haunt the capital markets. Speed kills—on the road and in the financial markets. As Goldman Sachs notes: 10-year U.S. Treasury yields have risen by 30 basis points (bp) to 3.2% during the past month, representing a 1.7 standard deviation move.2 We think the spike in rates was a one-off, but nevertheless believe investors will need to acclimate themselves to reflation and potentially higher rates in the future.
How much higher? No one really knows where peak yield may top out, but it’s worth noting amid the end-of world headlines of late that rising rates, in many cases, are associated with rising stock prices. On balance, in periods of market extremes, it’s important to step back and assess the economic fundamentals to determine whether the broader economy is still producing the level of growth (in both economic and corporate earnings) needed to support the current level of interest rates. Business cycles can often produce mixed signals, particularly cycles that have included a record level of central bank liquidity and ones that have lasted as long as the current cycle. That said, we still expect more upside for equities.
Where We Stand
To summarize our market convictions:
One, the recent sell-off, in our opinion, was less about deteriorating market fundamentals and more about a repricing of risk given higher yields and a correction of the excess built up in the high-growth, elevated valuations of pockets of the market (technology). Ergo, a technical, shorter term de-risking event that is likely to push valuations down to more acceptable levels, rather than a major change in the direction of the broader economy.
Two, the current pullback may be more about sector rotation and widening market breadth; as opposed to the narrowly tech and growth rally of the summer, five sectors have outperformed since the start of the month: utilities, staples, energy, financials and healthcare. The rally is broadening. And in another example of rotation within equities, value outperformed growth stocks during the six-day sell-off.
Three, despite the backup in interest rates and tightening monetary conditions in the U.S., we expect U.S. real growth and earnings to moderate in the months ahead, not deteriorate or decelerate sharply. Confidence levels of both consumers and corporations remain elevated, and on a relative basis, the financial health of both parties currently remains stable.
Four, as real growth slows in the quarters ahead, we do expect equity multiples to stabilize at a level that is more appropriate given the higher interest rates. Therefore, equity returns are likely to be closer to the level of corporate earnings growth (6%–7%) or slightly below long-term historical returns. We still expect stocks to outperform bonds and do not believe the end of the full cycle is imminent. If the yield curve begins to invert, where short rates rise above long rates, or if oil prices move sharply higher toward $100 a barrel, or if yield spreads widen out dramatically, we would lower our risk budgets and re-position portfolios more defensively.
Five, transitioning from a low-yielding, low-growth environment to a higher-yield, higher-growth climate typically leads to mixed signals and increased volatility. Therefore, in determining equity/bond portfolio allocations, we remain highly focused on the full Treasury yield curve, credit spreads, and whether or not earnings have peaked. At this stage, we still favor equities over bonds.
Six, we continue to favor long-term global secular investment opportunities related to the rise of the emerging market middle class; the global proliferation of the internet; the globalization of artificial intelligence and robotics; rising global health care expenditures; and exploding global demand for waste management.
Finally, a key lesson of the past few weeks: Investors should maintain a high level of diversification across and within asset classes. Whether bull or bear markets, portfolio diversification remains a key driver and determinant of long-term returns.