After a stellar 2017 and an even stronger January, risky assets have undergone a sharp pullback in the last week tumbling more than 10% from their peak on 23rd January 2018.
This correction in equity markets (which was long overdue) was partly caused by a spike in the yield on the US 10-year treasury which continued to rise as the market started to price in the possibility of a 4th interest rate hike in the US this year. Today, the yield spiked to 2.88%, the highest rate in 4 years.
The fact that the market moved lower very quickly was the result of computer-generated trades, which send equity markets into correction territory.
Why do higher interest rates result in a sell-off in equity markets?
Higher interest rates will eventually drag down economic growth because it results in a higher cost for companies and a strain on profitability putting into doubt analysts’ expectations of an increase in earnings by 15% in 2018.
The market was pricing in three interest rate hikes this year. Anything above that will create further volatility in the market.
Global stocks plunged into a correction territory on concern that rising interest rates Volatility spread across assets. The Cboe Volatility Index (referred to as the fear index) was more than double its level a week ago as equity markets erased all gains for the year.
Is the correction we are seeing normal?
Till now, a pullback of this magnitude is not of major concern, given the fact that we have been through a highly unusual stretch of market tranquillity. Many analysts are seeing the current pullback as being overdone.
Is a drawdown in the markets of 10% uncommon?
Moves of this overall magnitude are not uncommon, even if the speed of this week's drawdown has been surprising. Prior to the current drawdown, there have been 23 "bull market corrections" (market drawdowns of 10–20%) since 1940.
Should investors start to panic?
No. On the contrary, at these levels it starts to get interesting to start looking at getting back into the market. Although I remain concerned about the markets after last week’s harsh sell-off, for those with cash on account I would start adding slowing to positions particularly Europe and Emerging Markets.
Although it is impossible to call a bottom on the markets, and I won’t even dare, from a fundamental perspective, companies remain sound and a 10%+ correction starts to look attractive. We are not in a situation where (at least for now) the outlook for the companies we cover is at risk.
Why am I still optimistic about equity markets?
Fundamentals remain supportive of risk assets. The robust, broad-based global expansion continues and inflation will at last accelerate in 2018. I expect these trends to evolve steadily enough for central banks to tighten monetary policy gradually as planned. Strong growth and rising interest rates (but not at a fast rate) should continue to support corporate earnings and equity valuations, even as bonds yields steadily rise.
Which stocks will you be looking at picking up during this correction?
European
• BMW (ticker BMW in EUR)
• Renault (ticker RNO in EUR)
• ASML (ticker AMSL in EUR)
• Societe Generale (ticker GLE in EUR)
US
• Home Depot (ticker HD in USD)
• Mastercard (ticker MA in USD)
• Amazon (ticker AMZN in USD)
• Apple (ticker AAPL in USD
Emerging Markets
• iShares MSCI Asia UCITS ETF( ticker CEMA in USD)
• iShares MSCI EM UCITS ETF (ticker: IEMA in USD)
Conclusion
I expect 2018 to end the year with positive gains for global equities with particular preference to European and Emerging Market equities.
However, it is also true that pullbacks and volatility will become more common as investors adjust to rising interest rates. More volatility should not detail the underlying economic expansion or fundamentally dent risk assets, but it will make markets bumpier and less predictable.
Disclaimer: This article was issued by Kristian Camenzuli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.