2018 Market Recap Escape the Falling Knives
Feb 01, 2019
Asset prices declined: This past week, we observed a broad-based decline in asset prices - both bonds and stocks experienced sell-offs. Any observed asset price increases were likely the result of positive firm specific events or news. What is to blame for the decline in prices? When is a fall in price an indicator to sell or when is it an indicator to buy more? A combination of rising interest rates, an intensifying trade war between the US & China, heightened BREXIT uncertainty, and a decline in oil prices are a few of the factors fueling the sell-off. To the extent that the price decline is not a reflection of a deterioration in the credit quality or feasibility of the company’s business model – it could be a buying opportunity. However numerous buying opportunities are likely to present themselves over the next two years. It is advisable to resist buying at signs of the first sell-off.
Market recap: Let’s look at what happened to the prices of commonly held asset classes:
High yield bonds: Most USD denominated high Yield Bonds (i.e. bonds with a credit rating below BBB-) declined in price. Bonds issued by Tesla (B-), Netflix (BB-), Digicel (C) are considered high yield. The Bloomberg Barclays High Yield Index tracks the weighted average price (and yield) of USD high yield bonds in the developed markets. The “price” of this index has fallen by over 1.1% since November 8th and the yield on this index jumped to 7.04% on Thursday (from 6.94%); a 2.5 year high (source: Bloomberg). Bonds issued by the Government of Jamaica (B-) are also considered high yield and have not been immune to the sell-off. The price of Government of Jamaica 6.75% 2028 bonds are down almost 7% from a one year high of 115.9 to 107.
Equities: Equity indices also declined this past week. In the five days leading up to November 15, 2018, the Dow Jones had declined by 3.44%, the S&P 500 by 2.73%, the Euro Stoxx 50 by 1.46% , the FTSE by 1.44%, and even the illustrious Jamaica Stock Exchange was down by 0.6% on the week.
Why have prices declined? Here is a brief synopsis of the individual factors contributing to the sell-off:
BREXIT fears came to a head this week as a raft of resignations and a potential no confidence vote in the current Prime Minister upended markets. The pound weakened by almost 2% against the US dollar on Thursday alone. Key deadlines/milestones include the UK Parliament’s approval of the deal, which Prime Minister May is aiming to be done by mid-November, in time for a final vote on November 24th when all EU leaders will vote on the agreement. There is a lot of uncertainty around whether the Parliament will actually approve the deal and the resultant chaos it could create.
Italy budget impasse & German economy contraction: The EU recently rejected Italy’s proposed budget, citing that the assumptions on the expansionary impact of the spending package were too optimistic. German GDP contracted by 0.2% (more than expected) for the 3rd quarter of the 2018 fiscal year as a result of disruptions in car productions (that resulted from revised emission test requirements). While this contraction is not expected to persist, this heightened fears around the sustainability of the Euro area’s economic recovery.
Rising interest rates: Last week, The Federal Reserve kept interest rates unchanged (at 2% - 2.5%) but reiterated its intention to hike in December and 3 times in 2019. A tightening labour market, wage growth and a robust economy are building a strong case for a hawkish stance by the Federal Reserve. In theory, higher interest rates will negatively affect both bonds and stocks because future cash flows will be discounted at a higher rate. The ultimate fear is that the Fed will raise rates so high that it will put the US economy into a recession.
How to navigate: Caution is the order of the day. However, there are opportunities to do well in both asset classes, regardless of the interest rate environment. It’s important to note that higher interest rates are not a reason to abandon the fixed income asset class. Indeed, higher interest rates create more volatility and more trading opportunities. Similarly, the added geopolitical risks can create buying opportunities when the market overreacts to a particular phenomenon or to breaking news.
It always requires a bit of judgement, but the key is to determine whether the price decline is the result of a firm specific event or a broader market move that is affecting similar securities. For medium term bond investors, any decline in price does not affect your total return unless you sell. Your minimum return will be the yield to maturity that you purchased the bond at. Unless there has been a material deterioration in the credit rating of the issuer, there is no need to sell.
Marian Ross is an Assistant Vice President of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at [email protected]