There are plenty of reasons to be invested in European equities, the Swiss private bank argues.
The following commentary on market and investment issues comes from Ed Raymond, head of portfolio management UK at Julius Baer International, part of Zurich-listed Julius Baer. The comments here are a welcome addition to the debate. The editors here do not necessarily endorse all views of guest contributors and invite readers to respond. Email firstname.lastname@example.org
2017 was an outstanding year for global equities - with a combination of synchronised global growth and accommodative monetary policies worldwide - leading to double-digit returns across major indices with exceptionally low volatility. 2018 has been a different story altogether. February’s sharp correction, driven by a disorderly unwinding of crowded short volatility trades, set the scene for a bumpier ride for investors.
Some nine months on and we find ourselves in the midst of another market correction. The backdrop for the latest market turbulence is very different to that experienced in February, when sentiment was buoyant. Since that time the market has had to contend with global trade tensions, rising political risk in Europe and a divergence of growth between developed and emerging economies. Yet the catalyst for both sell-offs has been the same - a spike in US government bond yields - which is a topic worthy of deeper analysis.
Since the beginning of the year, the yield on the 10-year US Treasury has pushed higher, accelerating through the 3 per cent level. Yields at the front-end of the curve have risen in tandem, with the Federal Reserve continuing to normalise monetary policy by hiking interest rates at regular intervals, in response to strong underlying growth dynamics. Rising yields are typically positive for equity markets, as they signal continued strength in the underlying economy. Bond yields rise to adjust for higher GDP growth and inflationary expectations, leading to capital flows into equities that are better equipped to generate positive real returns in this environment.
There is, however, a tipping point at which higher rates begin to hinder equity performance. If rates move too high, expectations of future GDP and earnings growth rates decline, and investors are drawn to the higher returns available in risk-free assets, such as cash and government bonds, at the expense of equities. If past cycles are anything to go by, we still appear some way off this level, as the market has typically continued to reward equities with higher valuations up until the point that 10-year Treasury yields reach 5 per cent.
So, why are equity markets selling off? All of the move this year in the 10-year US Treasury has occurred in two swift adjustments, preceding both the February and the current equity market pullback, suggesting that the pace of movement in yields significantly influences the market reaction. In particular, an upward spike in yields appears most difficult for investors to digest, with rate volatility spilling over into equity markets.
The current market correction occurs against quite a solid fundamental backdrop and should therefore be transitory; however, a key focus will be on whether this turmoil will provide the catalyst for rotation, with new sectors or regions taking market leadership. The wildcard in the current market sell-off is the US technology sector, which has been the driving force behind the US market’s outperformance versus the rest of the world so far this year. On the one hand, the strength of balance sheets within the technology sector, which are flush with cash, helps to insulate them from higher rates; however, this is likely to be outweighed by the perceived impact that a spike in yields may have on future growth expectations within the sector, a force which is exacerbated by higher starting valuations.
A rising tide of rates does not float all boats. “Bond proxy” equities in low-growth, high-yielding sectors, such as utilities and telecoms typically suffer most as bond yields increase. Consumer staples with their long-duration, defensive-growth characteristics are also likely to come under selling pressure. Conversely, the primary beneficiaries of rising rates are typically financials. Not only do higher rates signify strengthening economic conditions, but banks further benefit from rising net interest margins, whilst insurance companies can invest premiums in higher yielding bonds.
With growth and inflationary expectations underlying the upward shift in yields, basic resources and energy stocks also have a strong platform to outperform, given their inflation-linked properties and demand intrinsically linked to global GDP growth.
Despite the ongoing market turmoil, the economic backdrop remains supportive of risk assets and we do not believe that the current economic cycle has reached an inflection point. It is more likely that a market rotation is underway, with investors protecting profits in US technology stocks. When the storm passes, this capital is likely to be redeployed in areas of the market offering greater apparent value.
If higher rates signify a paradigm shift, one wouldn’t bet against European equities leading the latter stages of the bull market, given a lower starting valuation and higher sector weightings in financials, energy, materials and short-duration cyclicals.