Don’t get defensive over sharemarket pullback

On Thursday, 11 October, the S&P/ASX 200 index dropped 166 points or 2.7 per cent, to 5883.80 points, firmly erasing all of the market's gains for 2018.

That was one dramatic day. But ANZ’s chief investment office has no expectation of a widespread market sell-off. This is an excessive claim, even though we have indications that the bull market in equities is facing greater challenges as the US Federal Reserve progressively tightens policy (pushing up rates), and the large US fiscal deficit eases, moderating global growth.

Given what we have been through in October, the following points must be considered.

• The US economy is growing strongly, with limited inflation and the Fed funds rate is still below levels that would seriously limit growth and cause a recession. Indeed, recent Fed commentary on the economy has been positive, pointing out its ability to cope with higher rates.

An inverted yield curve (2-year yield greater than the 10-year yield) has proven over the past 40 odd years to be one of the best indicators of a looming recession, but at this stage it is still positive. Furthermore, credit spreads, while wider this year, are still very tight relative to history. In general, sharply wider credit spreads indicate we’re heading into a recessionary environment.

Other financial indicators such as the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices also suggest credit supply to the economy is plentiful, and in the past, credit supply has tightened leading into a recession.

• News reports about rising bond yields and the US trade war with China as being key drivers of the sell-off should be read cautiously. Bond yields have fallen modestly during the equity market sell-off and the trade war with the US has been progressing since the start of the year and is not a source of new news in the past few weeks. We think the equity market sell-off is more due to the market reassessing late-cycle earnings growth, but not an earnings recession.

• Consistent with the reassessment of the earnings outlook, analysts in the US have started the process of downgrading the earnings outlook for the equity market. However, these downgrades don’t suggest earnings are about to fall off a cliff – they are better described as an expectation of an earnings slowdown.

Currently analysts expect earnings-per-share growth for the S&P 500 index, 12 months forward, to be around 11.7 per cent, following growth of above 20 per cent over the past year. We would be comfortable with this number dropping to high single digits over the next quarter or so. We consider a modest lift in costs (reflecting higher oil prices, higher wages and the impact of tariffs) will trim expected earnings.

We consider the current correction reflects the market moving to somewhat lower but still solid to- line earnings growth in 2019. Bottom-up stock analysts generally have a poor track record in predicting macro events such as an earnings recession, so we shouldn’t extrapolate out this shift in sentiment.

In this instance it is not surprising that the high price-earnings stocks in the market have been the worst hit, with lower price-earnings stocks faring better.

Putting volatility into context

A lift in volatility as such is not a major issue. One of the key reasons why equities deliver superior returns relative to defensive assets such as cash and bonds over the longer term is because they are attached to higher volatility and such volatility has been generally absent for several years.

We can point to the sell-off at the end of last year, in February this year and the current episode as being the only significant corrections during this period. Indeed, it is normal to have equity market corrections, particularly while the Fed is raising rates and we should view recent trading sessions in this way.

So we’re not changing our investment positioning for ANZ Private portfolios.

Overall, we continue to hold a broadly ‘neutral' position to most asset classes. However, we consider that a more defensive stance will become more appropriate in the next 12 months.

To discuss what this insight could mean for you, talk to your ANZ Private banker directly, or contact us below.