October: Anatomy of a Gruesome Month

The end of October, traditionally a time of frights and ghouls, brought with it a quite different kind of horror this year. It was a gruesome month for equity markets and for hedge funds. With November upon us, we think there’s much to be learned from a look back at October, both in terms of what such a pronounced drawdown has to say about the current state of the greed/fear continuum, but also about what might lie ahead as the bull market chunters towards its inevitable end.

22 NOVEMBER 2018

Introduction

The end of October, traditionally a time of frights and ghouls, brought with it a quite different kind of horror this year.

It was a gruesome month for equity markets – the Nasdaq tumbled 9%, the biggest monthly drop since November 2008. The S&P 500 Index lost almost 7%, its worst month since September 2011. The Hang Seng plunged 10%. China's Shanghai Composite declined 8%. Hedge funds had a particularly painful time of it, suffering their worst month in seven years1.

Now, though, with November upon us, we think there’s much to be learned from a look back at October, both in terms of what such a pronounced drawdown has to say about the current state of the greed/fear continuum, but also about what might lie ahead as the bull market chunters towards its inevitable end.

A Look Back

The 7% S&P 500 loss for October could have been much worse. Stocks rallied in the last few days of the month – as of October 29, the S&P was down 10.5%, which would have propelled it into the top-10 of the worst post-war months, just behind February 2009. Such declines are rarely a feature of bull markets. Indeed, analysts at BCA calculated that only seven of the 32 months in which the S&P closed down more than October’s 7% were outside of bear market territory. We are hesitant, however, to call the end of the bull run, as this episode could well be just another chapter in this extraordinary and unprecedented cycle.

2018 has been notable for the way that its two major selloffs have caught risk models by surprise. The surge in the VIX Index at the end of January and the beginning of February was entirely unforeseen and appeared to baffle models working off much lower average levels of volatility. Similarly, and notwithstanding the fact that the Nasdaq is still up year-to-date, the spike in realised volatility in the index in October appeared to catch many funds out, meaning that offloading of tech stocks by de-risking quant strategies over the course of the month exacerbated the downward spiral. At the same time, many of the worst-performing discretionary hedge funds in the US appeared to have been treating FAANG stocks as a kind of high-yielding risk-free asset, parking their money there while other investments stagnated. When prices began to plummet, they, too, were forced to sell.

Figure 1. Spikes in Realised Volatility in the Nasdaq

Source: Bloomberg; as of November 7, 2018.

Let us briefly anatomise the other potential causes of October’s selloff, some self-evident, others less obvious.

First, as we mentioned in our Views From the Floor on October 30, many companies have been under ‘blackout’ in October as they report their third-quarter earnings and have been unable to purchase their own shares. Indeed, US companies are accelerating their corporate buybacks, according to data from Deutsche Bank, with projections indicating that these may total about USD 800 billion by the end of 2018.

Figure 2. S&P 500 Net Buybacks (USD billions)

Source: Deutsche Bank, Bloomberg; as of September 9, 2018.

Secondly, October also witnessed the first time that US 3-month Treasury bills exceeded inflation since the Global Financial Crisis. If a lack of buybacks stripped demand in October, then this (admittedly relatively moderate) spike in rates was the indicator that seemed initially to spook the markets.

Third, comments by President Donald Trump about his dissatisfaction at the actions of the theoretically independent Federal Reserve’s decision to raise rates might also have played a role in the October selloff. Some additional risk premium might need to get priced into the US fixed income market if political pressure on the central bank becomes a regular occurrence.

We have long been of the opinion (and have expressed it numerous times in these missives) that the eventual move downwards would penalise all asset classes equally, and for a moment, with both bond yields gapping out and equities tanking, it looked like the realisation of many of our worst fears. It is worth highlighting that, according to a Deutsche Bank report, as of the end of October, 89% of all assets globally were down in dollars, something that has not happened since 1900, the longest the analysis looks back.

However, this was far from the stagflation nightmare we spoke about at the beginning of the year. Instead, the rise in rates was driven by continued strong economic data coming out of the US and by generally high-quality results (with a few notable exceptions). Yes, there’s concern about a potential up-tick in inflation, but this is inflation with GDP growth behind it, the kind of inflation that ought to be digestible for the equity markets.

As we mentioned in our Views From the Floor on November 6, we’ve recently seen a breakdown in a long-standing relationship: the correlation between inflation expectations and the ratio of cyclical/defensive stocks in the US market. What this says to us is that, potentially, the market is pricing in a near-term recession that may not appear. That bearish sentiment appears to have raced ahead of the data. Or is the equity market smelling a rat?

Figure 3. Correlation Breakdown

Source: Bloomberg; as of October 31, 2018.

Fourth, one of the things that has been very clear over recent months is how much the markets loathe uncertainty. Throughout October, it felt as if there were a huge number of unresolved issues that seemed to be coming to a head. Investors worried about being blindsided and so reduced their appetite for risk.

The most pressing of these issues was the possibility of a tail-event outcome in US midterms – the potential for many of Trump’s market-friendly initiatives to be rolled-back had the Democrats gained control of both houses. As it was, the result was neutral to supportive for stocks. There will almost certainly be policy log-jam.

There were other headwinds weighing on the market in October. In the increasingly intractable world of Brexit, the cloak-and-dagger activity of the hard-right of the Conservative Party seems to be gaining momentum with every passing day. Italy’s budget was also damping sentiment Europe, with the EU desperate to avoid allowing the coalition of M5S and Lega Nord to claim victory (and therefore send a message to other European populist parties). There was further disquiet after the election of Jair Bolsonaro, the first far-right Brazilian president since the return of democracy to the country in 1985.

Looking Ahead

We believe we shouldn’t be writing the US bull market off yet. Since 1946, there have been 18 midterm elections and US markets have moved higher in the following 12 months after every single one, according to Deutsche Bank. From yearly mid-term lows, stocks jumped an average of 32% over the following 12 months, more than double the average performance for stocks in all years. This is despite the fact that during that period, there has been every possible combination of political party in power in the two houses. Add to this the fact that the third year of a presidency has historically seen the best performance from the equity markets.

It’s China, though, that is likely to be the most prominent thorn in the side of a recovery into year-end, in our view. Firstly, there is the expectation that the G20 meeting in Buenos Aires at the end of the month will see some movement in the trade stand-off between the US and China. If the meeting between Trump and Xi Jinping in fact exacerbates tensions, then we enter a whole new realm of possibilities. We meet regularly with geopolitical analysts and it’s not unusual to hear the idea mooted that the current trade war is in fact the prelude to – or a proxy for – a more sustained conflict between the US and China. We don’t think in such catastrophic terms, and we believe that Trump will wish – above all else – to keep the economy strong into the 2020 elections. However, we remain cautious about the speed with which the current impasse will reach resolution.

Equally worrying is the fact that China’s most recent stimulus program appears not to be gaining the traction of previous efforts. The measures seem neither to have enthused the markets at home or abroad. There is a sense that the Chinese government is caught between plunging domestic stocks and the repeatedly stated wish to manage down leverage in the economy and reduce its reliance on old, polluting industries. Investors at home appear unwilling to take on more debt themselves, nor to put significant money into equities until the trade standoff is resolved. Consumer sentiment has also been damped by the dispute. There is even a more sinister view out there: given that the total amount of Chinese debt as a percent of GDP is at the same level Japan reached before it crashed in the 1990s, it is no surprise that attempts to stimulate credit creation are proving unsuccessful.

Conclusion

Where this leaves us is in a painfully familiar place, recognising that the equity market bull run is probably not over, but advising extreme caution as we move towards 2019. Since early January, we’ve said that these are dangerous times. It has been fascinating to see the twists and turns of the cycle of the course of a momentous year.We said previously that disciplined long-short strategies may be a good way to participate in continued upside when and if it materialised, while limiting downside. We’ve largely been proven right by events and we continue to hold that view. We are nearer the end now than we were then, but we expect further spikes and troughs before that final downward slide.

1. https://www.ft.com/content/faad2576-e2cb-11e8-a6e5-792428919cee

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