An Old-Fashioned Drubbing
The recent erosion in equities and other risky assets turned into an all-outlandslide last week and Monday morning. The S&P 500 Index, which suffered its worst day since November 2011, fell 5.79% to 1,970. The Dow Jones Industrial Average lost more than 1,000 points on the week, declining 5.82% to 16,459. It was the first time the Dow had fallen more than 1,000 points in a week since 2008. The tech-heavy Nasdaq Composite Index dropped 6.77% to close the week at 4,706. The plunge in stocks was accompanied by a corresponding spike in volatility, with the standard measure of volatility, the VIX Index, trading over 25 for the first time since last October. Meanwhile, with investors seeking so-called safe havens, the yield on the 10-year Treasury fell from 2.19% to 2.05%, as its price correspondingly rose. There was no single catalyst for the brutal selloff. Further weakness in Chinese data added to concerns over the health of the global economy. As we have been discussing during the past couple of weeks, the spike in volatility is consistent with two trends: slower economic growth and deteriorating credit market conditions. That said, we don’t think this is a prelude to another 2008-style cataclysm. Leading indicators are still positive and lower oil prices and interest rates should help stabilize growth. For investors, one key takeaway is that the selling has restored value in some areas of the market, particularly in Europe.Reduced Odds of a Rate Hike?
As with most selloffs, investors generally played to script. Defensive sectors outperformed while energy, certain momentum names (biotech) and cyclical stocks (semiconductors) were the hardest hit. Meanwhile, commodities, with the exception of gold, continued to tumble; oil traded below $40/barrel for the first time since 2009.
While investors abandoned stocks and other economically sensitive assets, they piled into safe havens, driving bond yields lower. Ten-year U.S. Treasury yields are now close to a four-month low. Yields in other major bond markets, including Germany, Japan and Australia, are following a similar pattern. At the same time, short-term rates are also falling, with the two-year Treasury yield down to 0.62%, roughly 10 basis points (0.10%) below the early August peak. Short-term yields are reacting to the decreasing odds of a September interest rate hike by the Federal Reserve (Fed). A few weeks ago, investors placed a 60% probability on a September hike. Today the odds are pegged at less than 35%.
Last week’s rout appears to be a delayed reaction to several developments: recent softness in credit markets, the selloff in emerging markets and general concerns over the state of the global economy. Recent U.S. economic data have generally been encouraging, but it is worth highlighting that much of the data have been consistently below expectations for most of the year. Adding to the anxiety, inflation expectations are dropping fast. If the Fed were to hike next month, this would imply a sharp spike in real interest rates (the interest rate minus inflation), a scenario that has historically been associated with more severe corrections for U.S. equities.
Finding Value in the Rubble
Absent better data, a more aggressive policy response from China or a clear signal that the Fed is likely to delay any hike, there may not be an immediate catalyst to settle the markets. That said, most leading U.S. and European indicators are still suggesting a continued economic expansion. In addition, the selling has restored value to certain parts of the market.
One example of a region that has been particularly hard hit, probably excessively, is Europe. Despite improvement in European economic data, companies exposed to global trade, particularly in Germany, have been singled out for special punishment. At this point, the selling may be overdone, especially since investors may be exaggerating Europe’s exposure to China. Overall, China represents just 3.7% and 5.4%, respectively, of eurozone and German exports.
European equities had already been sold hard prior to last week; in local currency terms, European and German stocks are now down 15% and 18%, respectively. The selling has pushed valuations down substantially. German equities are now trading at less than 12 times forward earnings and 1.5 times book value, roughly a 45% discount to the United States. While European growth is likely to remain lower than in the U.S., given the size of the discount and the fact that the major risk associated with Greece has been temporarily removed, the current discount suggests European equities once again look attractive.
Russ Koesterich, BlackRock
