Where we stand on the sell-off

President Donald Trump put the blame for last week’s equity market slide firmly on the Federal Reserve, claiming the central bank was “going loco” by raising rates too far, too fast. The S&P 500 dropped 4.1% over the week, the Nasdaq fell 3.7% and the MSCI All Country World index by 4.1%.

Rising rates are just one of several reasons for the sell-off, but we think it’s too early to suggest they mean the bull market is over:

Rising rates had made stocks relatively less attractive.

• The 10-year Treasury yield had risen to 3.25%. But, in a similar fashion to February’s equity correction, last week’s stock market decline halted, and partly reversed, the rise in yields that helped precipitate it. Importantly, while we have seen US Treasury yields move higher in recent months, we think they can continue to act as a portfolio stabilizer during times of equity market volatility. Furthermore, weaker-than-expected inflation data should help calm concerns about US economic overheating.

The US administration’s trade dispute with China is also a contributory factor.

• US equity markets had been resilient to rising trade tensions compared to other markets. A few companies exposed to China have highlighted pockets of sluggish demand. In addition, some companies have warned that the latest round of US/China tariffs will have an impact on their operations. That said, with the 3Q earnings season getting underway, we still expect corporate America to indicate that the earnings growth outlook remains favorable – we expect 23-24% earnings growth, on 7-8% revenue growth, for the S&P 500.

The CFTC’s Treasury market positioning data suggest China may have sold US Treasuries ahead of the Trump administration’s decision on whether to label the country a currency manipulator.

• This could have contributed to higher rate volatility and, in turn, higher equity volatility, prompting systematic accounts to reduce their exposure to stocks. However, CFTC data is noisy, so it is difficult to prove either way. And we see it as unlikely that China would resort to a policy of actively selling Treasuries to pressure the US administration, given the side-effects on its currency and domestic yields at a time when it is trying to add stimulus to the economy.

Technical selling appears to have amplified the move.

• Thursday's sell-off, in the absence of any clear catalyst, suggests forced selling by funds that target specific levels of portfolio risk, reminiscent of market moves in February. While short-term fund flows are highly unpredictable, technical selling can often present opportunities for longer-term fundamental investors.

In a higher volatility environment, further downside can’t be excluded. As we argued in our series of reports asking Are you prepared?, periods of rising volatility and market pullbacks are likely to become more common as the cycle matures, and this current bout may not yet have run its course.

But putting the decline into context, the S&P 500 has returned 5% this year, while earnings have grown by around 20%. Valuations have improved. The S&P 500 forward P/E multiple based on our 2019 earnings forecast is now 16.25x, down about a full point since the sell-off started. This is only slightly above the long-term average of 16.0x for the 12-month forward P/E. Against this backdrop the extent of the sell-off appears unjustified by the fundamentals. We remain overweight global equities and recommend that investors consider using the move to rebalance allocations.

Bottom line

President Donald Trump blamed the Fed for last week’s equity slide. But rising yields were just one of several reasons behind the sell-off, which also included concerns about growth and the impact of tariffs, as well as technical selling. Further downside can’t be excluded, but, against a backdrop of solid corporate earnings and better valuations, we don’t think the bull market is over.

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