Keeping the market volatility in perspective

Global equities resume slide

From the UBS Chief Investment Office

What happened?

Global equities have resumed their decline, amid renewed pessimism over the outlook for US-China trade talks and worries that economic growth is faltering. The S&P 500 fell 1.4% at the time of writing, following a 3.2% selloff on 4 November, and now has more than fully reversed the modest relief rally following an initially promising G20 meeting between Presidents Trump and Xi. China's CSI 300 fell 2.2% and the Euro Stoxx 50 index fell 3.3%.

Outside of equities, government bonds have rallied sharply – 10-year US Treasury yields have fallen 14bps over the week and now trade at 2.88%. In currencies, the Renminbi fell 0.4% against the US dollar, and has now given up its post-G20 gains.

The near 9% decline in global equity markets since late September still falls short of the standard 10% peak-to-trough definition of a correction. It is the sixth largest sell-off in global stocks since the bull market started in 2009.

What was behind it?

First, investors have grown concerned that a trade truce between the US and China brokered over the weekend could prove short-lived. Such worries have been stoked by a US request for the extradition of Meng Wanzhou, Chief Financial Officer of Chinese tech firm Huawei, suggesting that talks between the US and China are unlikely to be productive. The news follows a Tweet on 4 December in which President Trump referred to himself as "Tariff Man", arguing that higher import duties on Chinese goods were having a positive impact on the US budget.

At the G20 meeting the US delayed an increase in tariffs on USD 200bn of Chinese goods from 10% to 25%, which had been due to go into effect on 1 January. However, the US has warned that the increase will go ahead if an agreement is not reached after 90 days of negotiations.

Second, a flattening yield curve has been cited as a source of anxiety in various media reports. The closely watched spread between 2-year and 10- year US Treasury yields compressed to an 11-year low of 12 basis points. That raised the threat of an "inversion" of the curve, sometimes considered to be a predictor of recessions. This added to broader worries about a global slowdown. Earlier this week data suggested a continued deceleration in Chinese manufacturing, with the Purchasing Managers' Index falling to 50, the level separating expansion from contraction.

Finally, OPEC negotiations further contributed to volatility. The group unexpectedly cancelled its 6 November press conference, leading to worries that there is no agreement on production cuts. This caused a 4.6% slide in WTI crude to USD 50.8 a barrel, and sent stocks in US oil and gas firms 4.2% lower.

What is our view?

We believe that these concerns warrant careful monitoring. However, we believe the market has over-reacted and is now overpricing these risks.

The arrest of Huawei's chief financial officer reinforces our view that US-China tensions are deep rooted and will not be swiftly resolved. But much of this risk has already been priced into markets. And President Trump's willingness to delay the implementation of the January tariff increase was a welcome sign of flexibility.

Nor do we yet see the flattening yield curve as a definitive risk-off signal. For one, the yield curve has been flattening for reasons that are not necessarily negative for stocks, including more dovish signals from the Federal Reserve, lower oil prices, softer inflation, and a covering of short positions in bonds. While the yield on the two and five-year Treasuries inverted for the first time in over 10 years, we do not expect an inversion between the 3 month or 2-year yields and the 10-year – both of which have historically been better indicators of approaching recession. And even if 2s/10s did invert, this would not mean a recession is imminent, in our view. Recessions start, on average, 21 months after inversion, with a range of 9–34 months. Since 1960, the S&P 500 has rallied an average of 15% in the 12 months before the 2s/10s hits zero. S&P 500 returns have averaged 29% from the point that the curve inverts to the subsequent equity peak.

In addition, we believe oil is likely to recover from its recent slide. We should get greater clarity on 7 December regarding the magnitude of any production cut by OPEC and its allies, including Russia. We also expect global supplies to tighten as Iranian exports decline as US sanctions begin to take effect. It is worth noting that even if prices remain lower this isn't universally a bad thing. Although it would curb investment in the sector, lower oil prices could allow central banks to keep policy looser, and is also positive for consumer spending.

What should investors do?

The sell-off since early October has now left global equities at a roughly 15% discount to their average trailing price earnings ratio over the past three decades. With the global economy continuing to grow and positive earnings, we retain our overweight in global equities. That said, investors need to brace for higher volatility as the cycle matures and as US-China tensions remain elevated. We continue to favor incorporating counter-cyclical position, such as an overweight to 10-year US Treasuries, to help cushion the downside if tail risks materialize