2018 started the way 2017 ended – roaring higher. Then markets, which were severely overbought, reversed after bond yields rose significantly. Volatility shot up from all-time lows in 2017 (the VIX went from 9 to over 35 in a matter of days). One day in February saw markets fall precipitously as XIV products (short volatility) lost 95% of their value in a matter of hours. The S&P 500 along with other financial markets soon entered correction territory. Trump’s talk of a trade war sent markets down further. February saw markets have their first negative month since October 2016 while the S&P’s quarterly performance was negative for the first time since Q3 2015. Hedge funds also outperformed the S&P 500 for the first time since Q3 2015 except unlike that period the HFRX Equity Hedge Index was actually positive this time. It was interesting to note that during the sell-off low volatility ETFs fell more than the market, making their description a misnomer. Also, February and March saw FAANG stocks, which have been market darlings for the last few years, drop significantly.
Looking forward, the pace of the Fed’s balance sheet runoff is increasing to $30bn this quarter. This in addition to more debt issued as a result of Trump’s tax cut which should cause bond yields to rise further. The markets have priced in two additional rate hikes; however, there is a belief amongst some market participants that this could rise to three. The BOE is poised to raise interest rates in May and another time by the end of the year. This should hurt confidence in an already shaky London housing market. The ECB could send further hints that it plans to stop bond-buying by the end of the year while the BOJ could stop asset purchases soon. All of these moves point to the fact that volatility is here to stay. Also, higher interest rates benefit value stocks relative to growth ones.
Asia ex-Japan has decent growth prospects with moderate valuations - the MSCI Asia ex-Japan has a dividend yield of 2.3% and a price-to-book ratio (P/B) of 1.7. India should benefit from the fact that the speed bumps caused due to teething problems relating to recent reforms should go away. China under Xi is targeting the quality of growth rather quantity which should help debt in the country become more sustainable.
Japan looks cheap with the TOPIX trading on a P/B ratio of 1.3 while the normalised P/E is near the bottom of the last 45 years’ range. Earnings are expected to grow by around 11% although firms in the country are known for their conservative accounting. The country no longer has deflation while the output gap is now positive. The TOPIX did surpass 1,800 during the quarter which was considered the “iron coffin lid” for the past 26 years.
European equities look reasonably priced with the MSCI Europe trading on P/B of 1.8 and generating a dividend yield of 3.5%. The continent is witnessing strong economic growth with positive figures now coming from all regions. PMI figures have come in weaker than last year, but are still strong. Unemployment is falling. The ECB could signal that it is ending asset purchases by the end of this year.
US markets are fairly valued. The S&P 500, as a whole, trades on a P/E of 22 whilst it pays a dividend yield of 1.9% and has a P/B ratio of 3.2. The S&P 500 should see better earnings due to Trump’s tax cuts although this fiscal stimulus should lead to tighter monetary conditions.
Growth in emerging markets is strong although there are divergences. Given rising US interest rates investors should consider investing in countries with stable currencies and current account surpluses (normally those found in Asia) and avoid countries that have vulnerable currencies or current account deficits (Turkey plus some Latin American nations).