A bull market resetting, not an ending

It was a sea of red yesterday on Wall Street, with all major US equity market indexes closing down over -3% yesterday—the S&P 500 fell -3.3%, the Dow -3.15%, and the NASDAQ -4.1%.

Over the past week, the S&P 500 has experienced a -4.8% pullback. While significant, it’s important to keep these moves in perspective: the S&P 500 rose nearly 8% in Q3 and the year-to-date total return for the index is 5.8%.

We see a few factors contributing to this sell-off:

1. The recent rise in rates has made stocks relatively less attractive.

The 10-year Treasury yield has risen over 40bps in the past six weeks, including almost 20bps in October alone, as the market has priced in a more aggressive outlook for Fed rate hikes. As a reminder, the 10-year yield also rose 40bps in January—a catalyst for the early February market correction—before stabilizing for six months. Importantly for us, the 10-year yield fell as the market sold off today, and thus still functioned as a portfolio stabilizer.

2. US stocks may be belatedly pricing in the potential cost of tariffs on earnings.

In the past few days a handful of companies exposed to trade with China have discussed how the tariffs are starting to adversely impact their business through both higher costs and slower demand. US equity markets have been resilient to rising trade tensions compared to their global counterparts, leaving them susceptible to pullbacks as the costs become more apparent.

3. Rising rates have fueled concerns that the economy has entered the latter stages of the business cycle and thus growth will slow.

In the past week, defensive sectors have outperformed the market. Growth stocks are also down -6.7%, a result of the strong valuation expansion of momentum stocks unwinding. Meanwhile, value stocks are down only -3%, which shouldn’t outperform if there was significant risk of economic growth rolling over.

What hasn’t changed over the past week are the solid US economic and earnings fundamentals. With Q3 earnings season about to start, we expect EPS growth of about 23-24%, very similar to the first two quarters of this year. Granted, the focus will be on company guidance for future earnings, but for most sectors the tariffs announced thus far are not that impactful and underlying trends in even affected sectors (materials, industrials, tech, and consumer discretionary) still look fairly healthy. In addition, the strong growth momentum should enable the economy to readily absorb the higher rates, even if they continue to rise at a moderate pace.

Given the fundamental outlook, we continue to recommend an overweight position to risk assets in our tactical asset allocation. This includes an overweight in global equities and emerging market hard currency sovereign bonds. As a reminder, we reduced our global equity exposure over the summer because of our view that US trade policy had not yet been priced into equities. We also argued in our series of reports asking Are you prepared? that periods of rising volatility and market pullbacks are likely to be more common as the cycle matures.

Thus, we view the past week’s market action as fairly “normal” for this stage of a bull market that’s likely to extend for a while longer.

?Please visit ubs.com/cio-disclaimer #shareUBS