The market volatility this month took investors by surprise as major equity indices fell sharply at the start of the fourth quarter. Up to the date of writing (October 24), in the US the S&P 500 index has fallen 8.76 per cent, wiping almost all the gains for this year, resulting in an increase of just 0.88 per cent since the beginning of the year .

In Europe, the Stoxx 600 index dropped by 7.70 per cent so far in October for a total year-to-date performance of -6.40 per cent, while the UK FTSE 100 index fell by 7.01 per cent, resulting in a year-to-date performance of -6.21 per cent.

Asia was no exception, with its equity market dropping by 9.40 per cent in October to a year-to-date performance of -11.76 per cent as measured by the MSCI Asia Pacific index.

While some published earnings by US corporates have missed analyst expectations, the equity market weakness suggests that a broader market force is at play as opposed to company-specific news flow or financial results driving share price performance.

This argument is substantiated by the indiscriminate selling we have seen in the equity market over the past few weeks, where all sectors have been under pressure. This is particularly unusual when considering that approximately three-quarters of the companies that have reported their earnings re­sults so far in the US have actually exceeded market estimates while only a smaller number of earnings reports were disappointing.

Companies reporting positive results have not gained nearly as much as in the previous quarter when beating market estimates. Instead, we have seen passive selling across the equity market, showing little regard to the financial results of individual companies.

What seems to be at play is a broader economic dynamic that is shifting the underlying regime of financial markets.

Following several years of mone­tary easing and ‘cheap money’ in order to stimulate an economic recovery after the global crises, equity valuations have appreciated significantly, reflecting a very low interest rate environment and unattractive returns on low-risk investments.

In the meantime, major eco­nomies have indeed improved, which in turn supported the higher equity valuations. Particularly in the US, the latest GDP growth rate reported was of 4.2 per cent as at the second quarter of 2018, while unemployment continued to de­cline to a rate of 3.7 per cent in September. Market participants are now becoming more concerned that the ‘new’ forces of rising cost inflation and increasing borrowing rates could hamper the positive economic momentum.

Aside from the possibility of a slowing US economy, investors need also to worry about the un­friendly geopolitical developments across the other major economies. The political uncertainty in Europe is revealing once again the weaknesses of a fragmented European economy. The Brexit situation remains unsolved with less than six months remaining from the effective break-up date, which only adds to business uncertainty. China has reported mixed economic results which could also indicate a slowdown in the economy.

Yet, despite the weaker expectations on the global economy, the US Federal Reserve (Fed) is set to continue to normalise monetary conditions while the European Central Bank (ECB) is expected to shift its accommodative stance and to start increasing interest rates in 2019.

In fact, what seemed to have exa­cerbated the rout in equity markets are the latest Fed policy meeting minutes showing that they are firm to proceed with further interest rate hikes and some of the policymakers even supporting the possibility of increasing rates above their estimate of its long-run level, in order to be ‘modestly restrictive’.

This hawkish tone comes at a time when the market already deems the current pace of monetary policy normalisation to be rela­tively forceful. This is can be evidenced by the fact that the market- implied forward inflation rate in the US is circa 1.77 per cent – which is below the Fed’s forecast ranging between two per cent and 2.1 per cent for the next three years.

The ensuing move was a sell-off in US Treasury pushing the 10-year yield above 3.20 per cent – a level that was last seen in 2011.

Given all of these factors, confidence about current earnings re­ports is resulting in greater worries about future success. The profit warnings issued by a mi­nority of the companies that have reported results seem to be endorsing these concerns.

Corporate earnings in the US are expected to increase by 11 per cent next year, which is still relatively high, but the level of uncertainty around this estimate is rising. This reflects an environment where expectations suggest that corporate earnings may have actually peaked – but is this really the case?

The crux lays in the metaphoric tug-of-war between the expected growth rate of future earnings and the impact of higher inflation and higher borrowing costs on corporate profitability. It is the reassessment of these factors that is influencing equity valuations, reflecting a meeker outlook for equity market returns and a challenging path for economic momentum.

Matthias Busuttil is senior portfolio and investment manager at Curmi and Partners Ltd.

www.curmiandpartners.com

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.