For the cause of the recent market dip, we think the bond market is probably the best place to look. That, mixed with some lumpy algorithmic sell orders and general market complacency. 
There’ve been a lot of trade threats – and action – over the past month, and then there was Hurricane Michael making landfall roughly at the same time US markets took a tumble. To top it off, China’s numbers have been getting steadily worse.
This has led to some concern that global demand is about to fall significantly. But equity market corrections greater than 10 per cent are rare during the expansion phase of the business cycle, nor is the economic data pointing to an imminent end of the expansion at the moment. We’ve been here before during the current economic recovery, already one of the longest recorded. Equity markets took a similar turn for the worse in February, following what appeared in hindsight to be a short-lived inflation scare, only to recover and subsequently reached new highs across the globe.
‘A long way from neutral’
It appears most likely to us that the recent sudden and sharp drops in global markets were triggered by a rise in US yields. On 3 October, US Federal Reserve chair Jay Powell said interest rates, which were raised to 2.25 per cent last month, were “a long way from neutral”. Almost immediately, US Treasury yields took flight; by 9 October the 10-year yield was 18 basis points higher at 3.25 per cent. Short-term bond yields moved upwards too, but by less. Before these moves, a small spread between short and longer-dated yields was being cited as an indicator of rising recession risk. But at the time our analysis showed the yield-curve implied probability of a recession in the next 12 months at just 20 per cent. This is now even lower.
Suddenly, the cost of capital – how much return shareholders and creditors demand for risking their cash – was significantly higher. The effect on stock markets was instant: the value of all the cash you expect businesses to make for you in the future is much less. And if you factor in the worries about Chinese growth, general nervousness about trade and a tick down in US PMIs (surveys of businesses that tend to lead harder economic figures), perhaps there won’t be as much of those future earnings either. That would push values lower again. So, you have a correction in markets, with the S&P 500 down 7 per cent, the FTSE 100 down 7 per cent, and the Shanghai CSI 300 down 9 per cent.
Rolling over, but still going
The annual rate of change in our own global leading economic indicator has turned negative, which is not good news for cyclical (economically sensitive) sectors like basic resources, alternative energy, autos and parts and leisure goods. But it’s still signalling a decent amount of growth, which to us means we should stay invested.
Technology and companies that have done well over the past couple of years were hard hit, and so were cyclical sectors. The strong performers tend to be on higher multiples of earnings and therefore their prices are more vulnerable to a rise in the cost of capital. Even though, from a business standpoint they actually have the low debt levels, stable earnings and high margins that allow them to take higher costs in their stride. We think they could do well, at least in relative terms, if a slowdown does happen.
We know this is pretty cold comfort to investors, as the last couple of weeks have been painful. In the coming months economic growth may slow, companies may lower earnings guidance; but the economy could be perfectly fine and shrug off the rise in yields. Either way, we think quality companies – those with low debt and strong cash flows that are less reliant on greater economic growth – are the best bet for the future.
An unusual correlation
What makes this sell-off so jarring could be that bonds and equities have gone down simultaneously. Portfolio management 101 says that when equities fall, safe haven bonds tend to gain in price. That negative correlation broke down in the past couple of weeks – as we said at the beginning that’s because the fall in bond prices sparked the fall in equities. Still, we think bonds will continue to be a good balance to portfolios in the long term, but short term we could be in for more bouts of simultaneous falls if the pace of US monetary tightening carries on unchanged and economic growth starts to tail off. For now, we continue to see this latest dip as a short-term phenomenon, and nothing out of the ordinary in the course of a continuing expansion. As long as the economic indicators continue to signal decent growth, we believe the best course of action is to stay invested and keep an eye out for bargains among quality assets with good long-term return potential.
Julian Chillingworth is chief investment officer at Rathbones. The views expressed above are his own and should not be taken as investment advice.