#Investments — 23.10.2018

No End In Sight For The Longest Equity Bull Market Ever

Roger Keller

Equity markets are undergoing a period of doubt. Uncertainties are unlikely to disappear in the near term and volatility is likely to prevail too. The medium-term outlook remains favourable, and should mostly benefit pro-cyclical markets and sectors.


The “October effect” or the start of something worse?

Since 1928, the US stock market has delivered negative returns in the month of October on 39 occasions. The year’s tenth month got the reputation of being dangerous for stock investments because of the Panic of 1907, the Great Crash of 1929, Black Monday (19 October 1987) and the Great Crash of 2008.
We do not think investors should be too concerned about the “October effect”. Statistics are interesting but we would not attempt to look for meaning in these numbers.

In a similar vein, we do not see anything meaningful about the 80% success rate of the Super Bowl indicator “predicting” the market trend (down if a team of the American Football Conference wins, up if a National Football Conference team wins). These are purely correlations and no causalities should be found here. Moreover, September is historically (over the past 90 years) the weakest month of the year, and the month that has registered the highest number of negative returns. 

In the first half of October (this year), global equities lost approximately 6%. There are two main causes for this decline: rising bond yields and concerns over the impact of US-China trade tensions on corporate margins. As we explain below, we do not believe that the end of the bull market is in sight. 

Two main causes

The sell-off movement occurred just before the start of the US earnings season, as fears about the negative impact of US-China trade tensions on margins intensified. These fears emerged after earnings reached a peak growth rate in Q2. Earnings are now beginning a transition towards more sustainable rates of growth, raising the question of whether valuations are excessive, particularly as the Federal Reserve is tightening its policy.

The second main cause of the recent sell-off was the 40 basis point rise in bond yields. It is worth noting that the sharp fall in equity markets last February also followed a significant rise (+55 bps) in bond yields.

We cannot exclude further damage in the coming months, for the reasons detailed below. But to fear that it will become a bear market would imply fearing the start of a recession in the next 12-15 months, which we do not foresee. 

Late in the cycle but not at the end

The current period of economic expansion is the second longest on record, based on US data. It would become the longest if it lasts until July 2019 at least, which we believe is highly probable. There are many signs that the current economic cycle has reached a mature stage: for example, US jobless claims have reached a five-decade low, global consumer confidence is elevated and corporate margins have improved substantially.

Moreover, there are also many signs that the current expansion is unlikely to end soon. First of all, cost pressure on companies remains moderate. Secondly, job market and wage trends comfort good consumption prospects. Thirdly, investment spending, as a share of GDP, is still moderate and the appetite to invest is clearly present. Fourthly, interest rate levels remain moderate, in both nominal and real terms, and supply/demand credit trends are favourable. Finally, risks on global trade remain manageable.

The upshot of all these economic trends is that earnings should continue to grow in 2019.

Consensus expectations look too optimistic but a 5-7% growth in earnings in 2019 would be sufficient to build a positive case for equities over the next 12 months, given that valuations are fair, based on PEs, price-to-book ratios, dividend yields or when comparing with bonds.

A dearth of positive drivers in the short term

The issue for us is not the medium-term but rather near-term outlook. We struggle to find positive catalysts. Firstly, global liquidity is retreating, as monetary aggregates, the world monetary base and the trend in central bank balance sheets testify.

Secondly, the global composite PMI confirms that 2018 is a year of peak growth and that activity is set to decelerate. It will take some time before investors are convinced that 2019 will be a year of solid expansion. Meanwhile, positive and negative economic surprises are offset.

Thirdly, the political environment will remain unsettling. Firstly, the European Commission could soon give a negative opinion on the Italian budget and ask for revisions of the spending plans; if Italy remains inflexible, then Brussels could begin a so-called “excessive deficit procedure” which could ultimately lead to financial sanctions to the tune of 0.2% of GDP. Secondly, Brexit uncertainties remain elevated; good will is apparent but obstacles remain significant, raising the chances of an extension of the transition period and hence persistent uncertainties. Thirdly, the US mid-term elections are fast approaching and all eyes will be on the gains that the Democrats will chalk up. Finally, US-China trade tensions will probably drag on.

Finally, the technical picture is uninspiring now that key support levels have been broken and the 200-day-moving average trend is deteriorating. In addition, sentiment indicators are neutral, as are the relative strength index and the moving average convergence-divergence indicator.

Given these considerations, markets should remain directionless and volatile in the near term. 

Positive investment implications

Looking further ahead, our base case scenario is that the world economy will keep growing in 2019 and the outlook for equity markets will remain favourable. Once investors are convinced that this is the case, a positive momentum should begin, allowing pro-cyclical markets (euro area, Japan and Emerging Markets) and pro-cyclical sectors (energy, financials, materials and industrials) to deliver above-average returns. Investors should thus focus on taking advantage of periods of stress to raise their exposure to these areas.