The reversal of the sudden technology stock slide that sank stock markets in early October should help revive equity and bond values.
This article was written in early November for the December 2018 print edition of Money Observer. Market data and share prices are likely to have since changed.
The MSCI All Country World Index lost more than 8% in October, the biggest destruction of value in a month since the financial crisis of 2008. The situation is now stabilising, but for investors who had held the belief that portfolio diversification protects against losses in a crisis, the past few weeks have proved a rude awakening.
In the past, bond investments have typically rallied when equities faltered. However, almost every major asset class has fallen in value this year. The MSCI International World Index is down by about 2% on the year and the global bond market has lost more than 3% – only junk bonds have stayed in positive territory. The Bloomberg Barclays US Aggregate Bond index is set to post its second-worst year in history.
Even worse, poor returns from fixed income exacerbated the sell-off, forcing investors who were trying to protect their portfolios to sell. The tactical asset allocator portfolio, for example, holds the iShares TIPS Bond ETF, which should be a defensive corner of the US government bond market, but even two-year Treasuries have slipped.
Infrastructure and ‘real’ assets such as property and commodities can be sources of diversification, but they are affected by the general economic outlook and access is typically through quoted stocks, which suffer contagion along with everything else. Even gold has been sluggish, its price having only climbed to a three-month high of $1,233 at a time when it might have been expected to soar.
China bonds are one asset class that could offer real diversification benefits. Having outperformed against developed world peers over the past five years, their performance diverged further this year. China bonds will be included in the Bloomberg Barclays Global Aggregate index from April 2019, which should help them attract steady inflows and boost foreign ownership, currently standing at just over 2%.
Investors can access the asset via ETFs such as the VanEck Vectors China Bondfund or the Invesco Yuan Dim Sum Bond ETF, both of which trade on NYSE Arca. As its name suggests, the Invesco ETF tracks bonds in the yuan-denominated dim sum bond market. The yuan could appreciate as the Chinese government loosens its controls, making the ETF useful as a diversification tool in portfolios with a heavy weighting to the dollar debt of US issuers.
The yuan has hovered at its lowest since the financial crisis in 2008, having fallen by more than 9% against the dollar since January. As well as buckling under pressure from the US Federal Reserve’s agenda of hiking interest rates, the currency has weakened on fears about China’s slowing economy. The exchange rate is edging towards 7 yuan to the dollar, which is seen by investors as an important threshold that once breached could trigger a run on the currency.
However, the Chinese government intervened forcibly to prop up the yuan in 2015 and 2016, and it will do everything in its power to prevent it falling further, because this would damage the stock market, whose companies are carrying large debts in dollars that become more expensive as the yuan slides. That process began in the last few days of October, and the currency rebounded a little following a central bank statement that measures will be taken to defend the yuan against short-sellers.
So is the worst over? The steepest daily fall was caused by investors panicking at third-quarter results from Amazon and Alphabet, but tech stocks, bar Apple, have largely recovered. Arguably, the meltdown seemed particularly shocking because it came after an unusually calm period. The S&P 500 index had not seen a single 3% decline in a trading session in the year to November 2017, but last month it dropped by this magnitude in three separate bouts. Pre-2016, falls of 5% and even 10% were commonplace. Unsurprisingly, when 5% declines occur in quick succession, the second decline has typically been sharper and recovery slower.
Goldman Sachs predicts that the S&P 500 will recover to 2850 by the end of the year with a rebound of around 7%. Its analysts point out that over the past few weeks, there have been few share buybacks as companies prepare to reporting earnings, and that the market has been missing this activity, as corporates are the primary buyers of shares.
Trade war tension
The running sore has been the trade war between the US and China, which has morphed into a deeper and more protracted conflict than might have been expected. However, presidents Trump and Xi are due to meet at the G20 summit in Argentina in late November, and the market seems to believe a compromise will be worked out to avert the disaster of a 25% tariff on both sides of the Pacific.
It seems increasingly likely that the US Federal Reserve will hold back from a fourth interest rate increase this year at its December meeting, as the US economy may not be as robust as is believed. This might soften the dollar, the strength of which has been a real drag on performance around the world – particularly that of nations with big current account deficits and high levels of dollar debt. Emerging markets such as Argentina and Turkey have been hit, and these markets still look relatively cheap.
Another opportunity for dip buyers could be European oil majors, as a weaker dollar would boost oil. Royal Dutch Shell and BP, and indeed Eni and Total, all look oversold, particularly compared with their US counterparts. What’s more, they pay dividends of more than 5%, which is a useful source of income when capital values are volatile and fluctuating, and will of course be more appealing if interest rates are not hiked as steeply as expected.
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