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Aon Retirement and Investment Blog

Yet Another Market Swoon

Summary

  • This is yet another market swoon this year with no obvious culprit behind it.
  • We see this as one of possibly several transition environment drawdowns, reflecting the onset of difficult conditions this year.
  • The factors driving equity markets are showing up as still mostly unsupportive, but not at such critical levels that suggest imminent danger.
  • The volatility shock this time is smaller than in February, assuming we return to calmer conditions in the coming weeks.
  • Since the market drop is not a surprise in this environment, it should not be driving any strong actions.
  • We identify three types of investors and their likely actions in this market environment.
  • The majority looking to strategically de-risk away from equities will want to wait for calmer conditions to sell. On a global basis, equities are not that far away from their highs, though it is true that non-US markets have fallen harder.

Another swoon with no clear trigger

At this time, the swoon in October is shaping up to be fairly similar to February's – a little under 10% for the MSCI World index.

The other similarity to the February swoon is that there is no obvious single trigger. Sometimes, though not very often, a single piece of news can legitimately bear most of the responsibility for a large market move. This was not true of February and neither is it true now, which is consistent with the observation that most large market moves come from a very complex mix of factors. All we know is that there have been more sellers than buyers recently.

Of course, post event, many will rush towards single explanations behind the rush to sell. The fact that there are many such 'explanations' for the current swoon points to the reality that it is the classic pattern of a complex interplay of factors that are behind the move.

Drivers allegedly to blame this time go across a wide spectrum. They include: concern about an economic slowdown in the US (even though conditions are currently robust); a decline in profit margins (profits are strong with little to suggest they are about to fall off a cliff); rising US interest rates (the Federal Reserve has made its intentions clear all along and for all of this year the market has accepted that interest rate reality); a slowing China (China has been in a restructuring and deleveraging mode with slower growth for several years); geopolitical tensions including trade wars (again something that we have seen for quite some time); and also overheated US technology stocks and risks of disappointment (also not exactly a new development); There are even more 'explanations' on offer if you care to look.

The truth is that we will never know exactly why markets have dropped this way. It could be all of these factors in combination or it could be something very different such as technical or momentum selling as the S&P 500 went through various moving average points (it did dip below its 200 day moving average and this might have been a contributory factor in selling seen in the last few days).

It matters little that we do not have a complete understanding of what caused markets to drop this way in October. What does matter is that we understand the aggregate picture, the range of supports and vulnerabilities for the market. It is when this balance of factors swings a bit more in one direction or other, that large moves, either higher or lower, occur.

Transition environment drawdown 

All year, it has been rather obvious that earlier supports to equities have weakened[1]. Equally, it has not seemed as though the conditions for really big market falls that define a 'bear market' (falls exceeding 20%) are with us.

This is still true, though our view that 2018 has seen an entry into a transition environment means an expectation that typically and ultimately, markets will migrate towards one. Though non-US markets have fallen much more and for longer, it is ultimately US markets that are critical in this call. While our view has been that markets have been vulnerable to more volatility and drawdowns this year on account of diminished supports, we have also argued that the ultimate bear market did not appear that imminent.

Below, we take the key factors (or more correctly, factor 'groups') that have a bearing on the call, and add an assessment on how well markets are supported, shown here as a subjective assessment of the level of danger. As always with bear markets, pinpointing the timing is extraordinarily difficult, but what we can do is to check for an accumulation of bad factor developments and bad news alongside that could collectively trigger a tipping point.

Indicators concerning but short of 'critical'

True now as it has been for most of the year to date, the indicator groups discussed below are signaling a difficult outlook overall, balancing 'glass half full' and 'glass half empty' views. This is the reason why we have taken the view that markets have been in transition this year. Equally, however, they do not look to have reached a point of such danger that the sustained large market falls characteristic of a bear market are imminent.    


Most of these factors will be familiar. We show green as a factor group which is market supportive or unlikely to be a bear market trigger (sentiment, credit market conditions and trend following/volatility trading), with more difficult conditions shown in amber (absolute and relative valuations, economic growth, financial stress and geopolitics)  None are now a critical 'red'.

The newcomer into our monitoring is taking a harder look at indicators of 'financial stress'. We follow a range of these, and clearly they can mean different things to different people. We interpret them as a set of indicators that pick up stress in financial markets. Though the broad picture through the undergrowth of numbers here is reasonably calm, one particular financial stress indicator is troubling; the stock-price behavior of so-called 'systemically important financial institutions' (or 'SIFI', as defined by the Financial Standards Board) is suggesting stress. Though the price drop is smaller to date than the 2015/16 period when fears of a recession arose, it is an indicator of growing difficulties for banks globally, admittedly less so for US banks than elsewhere. 


All told, our central expectation is, as before, that equity markets are struggling to make headway, and that what we have seen, for the second time this year, is mainly a volatility shock. That said,  the volatility shock appears smaller. The VIX index, the standard volatility barometer rose more last time (see chart below).

What should be done? 

The assessment that equity market conditions are challenged reflects the view that has been taken this year that these are better selling than buying conditions. On its own, therefore, this market drop should not precipitate any action. The ideal is to follow a set of incremental moves that take portfolios towards bearing less equity risk. This should be moving in line with strategic portfolio direction. As before, this stance on equities is more actionable for those portfolios currently carrying substantial equity risk.
  • For those looking to sell, reflecting the strategic direction towards de-risking as portfolios mature, the question that is being asked is whether these are still reasonable levels to sell. Of course, the timing of sales can and should be fine-tuned to take advantage of a market bounce in the coming days/weeks. However, given large market gains banked over many years and that indices are still only down a few percent off their highs this is still not a bad time to sell equities. This is on a global basis.
  • In the less common position for institutional investors looking to 'buy', these are better levels to buy than earlier, given equities are currently down year to date. The key question is over investment horizons. On a long-term view for investors who can ride out a bear market or difficult market conditions for a few years, DC-type investors for one, some buying looks reasonable to do, though it should be understood that risk-adjusted return prospects will not be that good for some time. This matters, because for shorter-term time frames of say 2-3 years, these still do not look attractive enough entry points to be doing much buying given limited upside and the possibility of more shocks. For these reasons, at least some buying firepower should ideally be retained.
  • There may be a third category of investors who find themselves underweight in equities and are wondering whether to 'rebalance' back to target. Of course, almost no liquid asset class has performed well this year so this is unlikely to be a widespread phenomenon. Rebalancing back to target is reasonable to do for already well diversified portfolios.
Tapan Datta is the Head of Aon’s Global Asset Allocation Team based in London
[1] AA View: Not all bad for global equities but supports are weaker, April 2018

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