With the recent correction in the USA, US share indices have started to copy the weak share price performance in the other markets. Before this, the boom enjoyed by the tech stocks (known under the acronym FAANG stocks) as well as the positive effect of the tax cuts had lent the American equity markets a degree of buoyancy that was lacking in this form in the other markets. On the contrary, many European companies have suffered from mounting uncertainty about investment as a result of the USA’s “America First” policy.
So far the correction has not been unusually pronounced. On average, since 1975 the DAX has corrected intra-year by 18% from the local high to the next low. So the decline in DAX share prices from this year’s high (18 per cent) is precisely in line with the average. Only a DAX level below 11,000 points would be unusual. The Euro Stoxx 50 has corrected this year (-15% from the high) less than the average since 1990 (-19%) and the S&P 500 is also a long way off the average measured correction of 14% with its peak share price loss at nine per cent.
Four weeks ago the investor-world was still in order. The global economy was stable despite various political stress factors, corporate profits were growing. In Europe the Brexit negotiations were possibly coming to an end and the Italians were disgruntled with the EU – to this extent no unusual news. In the USA everything went somewhat better than in the other industrialised countries thanks to the tax cuts and the profit-driving technology stocks. But US companies are increasingly reporting that the higher tariffs in their business with China are leading to higher purchasing prices, which could lead to lower profitability. This has been interpreted by the market as meaning that the US economy’s growth momentum is about to flag. But in our view, the main reason for the correction was because American technology stocks had run very hot. Indeed, these stocks have now corrected strongly (apart from Apple) so their valuation now looks somewhat better.
In addition, the concern about rising US bond market yields had a negative impact on the equity markets as yields on 10-year US government bonds dug in above the three per cent mark. Some market players had already become jittery for the first time in spring when yields overshot this mark.
Interest rates dictate the price of money. If central bank key rates rise significantly (and thus bond market yields, too), then companies (consumers) draw down fewer credits and/or save money instead. The economy then grows less strongly, with corresponding dampening effects on the companies’ profits.
Rising yields also have further implications for the equity market: Among other things, companies are worth less in the traditional valuation models because their future profits are discounted with a higher interest rate. In addition, rising interest rates increase the competition between the asset classes equities and bonds. Equities become less attractive. In the fourth mechanism of action the rising interest rate effects the loan interest rate that the companies have to pay on their debts and their interest expenses increase. In practice these effects are mitigated, e.g. by higher sales revenues resulting from rising prices (inflation) or because many companies have few or no debts (e.g. many large US technology stocks), and finally by the banks, which earn more money.
A look at the past shows that equity markets tend to undergo phases of weakness as of a US yield level of around four to five per cent – in this cycle perhaps even already at a lower level. But we do not expect such a significant jump in yields at the moment. For the foreseeable future we expect US bond market yields will be below 3.5%. Any shift out of equities and into bonds is also likely to be a gradual process among investors and will not occur overnight.
Are further corrections to be expected?
The economic and equity market upturn has been underway since 2009. We assume that the end of the boom has now begun, but that the economic upswing could still buoy the equity markets for one to two years. The fact that there is no intrinsic overheating in the equity market itself in the form of a broad-based valuation bubble and that capital market yields on either side of the Atlantic will probably increase only very slowly also suggests that the upswing will continue. Nevertheless, we expect that uncertainty will build up in the late phase of the economic cycle and that corrections will occur more frequently. In line with our market opinion, we believe the low share-price level is promising for equity purchases.