It took little time for equity markets to resume the selling and volatility that characterized the end of last year. On the second trading session of the new year, the S&P 500 fell by 2.5 %, led by a 5.1% decline in the tech sector. US Treasury yields also continued their decline, with the 10-year yield down to 2.56%, the lowest level in almost a year.
Why did this happen?
Equities sold off in response to a flurry of negative headlines that have greeted investors returning from the holiday season. The bad news started on Wednesday with the release of Chinese PMI manufacturing data that had entered contraction territory for the first time in 19 months. It continued on Thursday, first when US tech giant Apple cut its earnings outlook for 4Q18 by about 10%, rekindling fears that smartphone demand had peaked. Then the closely watched US ISM Manufacturing index came in at 54.1 for December, below consensus estimates of 57.5, and down from November's 59.3. Even more dramatic was the fall in the new orders component: 51.1 vs. 62.1 in November. These declines were likely distorted by companies front-running an expected increase in the US tariffs on China originally scheduled for 1 January.
But they have heightened investor concerns about slowing US and global growth. In addition, the partial US federal government shutdown and political rancor in Washington have exacerbated the uncertainty.
What's our view?
Equity market valuations have clearly fallen in the sell-off. The S&P 500 entered last year at 18.5x forward earnings; it is now trading at 14x, below its long-term average of 15.2x. Global equities are trading around 13x forward earnings versus a long-term average of 15.7x. But greater short-term support for markets will likely materialize only when greater clarity about trade disputes emerges and leading economic indicators begin to stabilize or rise. While these uncertainties persist, investors should expect volatility to continue.
The decline in valuations suggests that this could prove to be a good long-term entry point. That said, significant uncertainty about the short-term path for some key market drivers remains, so investors should prepare for further volatility with countercyclical positions like exposure to the Japanese yen and a put spread.
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