Capital Ideas^™ 
Investment insights from Capital Group

Upended by rising Treasury bond yields, volatility has returned to global stock markets as investors grapple with concerns over tighter U.S. monetary policy, a brewing trade war and slowing economic growth in China. The CBOE Volatility Index, or VIX, has moved higher and stocks have pulled back in October. The selloff has been led by declines in the shares of technology companies, including many of the names that consistently drove equity markets to new highs during a nearly decade-long bull market.

“The stock market pullback is not particularly surprising when you consider that rates are rising, the labor market is tight and the Federal Reserve is removing some liquidity from the system,” says Capital Group economist Darrell Spence. “Equity valuations were also elevated, and the market had been underestimating what the Federal Reserve said it was going to do in terms of increasing short-term rates. And there is a trade dispute with China that could put further pressure on the economy.”

Indeed, investors should expect more volatility ahead as we approach several potentially market-moving events, including the U.S. midterm elections, further Fed tightening and the withdrawal of crisis-era stimulus measures by the European Central Bank. We see several factors that could continue to spur market volatility. Here, we discuss five of them:

1. Rates are rising and the Fed is removing monetary accommodation.

U.S. equities may have been due for a pullback, but part of the answer lies with the bond market. The rapid rise in rates in recent weeks was the immediate trigger. It is not so much the direction that has surprised markets as much as the pace of the bond market reaction, with the 10-year bond yield touching a seven-year high of 3.23% intra-month before ending October at 3.15%, and the 30-year bond yield hitting a four-year high of 3.4% and ending the month at 3.39%.

That’s sparking market volatility amid rising rates and the end of quantitative easing. There will be continued tightening as long as the pace of economic activity remains elevated and inflation expectations are rising. “As the Fed moves from quantitative easing to tightening policy, it is more data dependent in its timing,” says Mike Gitlin, Capital Group’s head of fixed income.

Unemployment and inflation, the latter measured by the core personal consumption expenditures (PCE) price index, are the two most important factors the Fed considers when deciding whether to raise rates. What the data tells us today is that the U.S. job market is very strong: The unemployment rate hit a 49-year low of 3.7% in September. The employment cost index, a broad gauge that measures wages and salaries and is closely monitored by the Federal Reserve, increased 0.8% in the July-September period from the prior quarter. And U.S. inflation remains near the Fed’s target, with the core PCE up 2% in September from a year earlier. These figures indicate that the Fed is likely to continue hiking interest rates into the foreseeable future. Our fixed income team expects another rate increase in December to 2.5%, with an additional two to three more hikes likely in 2019.

2. The pullback in technology should not be a surprise.

Technology has risen to become about a quarter of the S&P 500 index, and if you throw in Netflix and Amazon, the weight is roughly 30%. These companies have had an outsized effect on market indexes – in both directions. Moreover, program trading has likely contributed to sharper moves in markets, leading to higher volatility.

Shares of technology stocks, and the FAANG (Facebook, Amazon, Apple, Netflix and Google owner Alphabet) stocks in particular, pulled back in October. Amazon traded lower despite posting record earnings, as its 29% sales growth was below expectations, in part due to the slowdown in retail. Facebook also reported strong earnings, but was more cautious with future guidance. Netflix shares also tumbled in the month after nearly doubling in the first nine months of the year.

But it is worth keeping in mind that the technology sector gained 11% year-to-date and has soared nearly 600% since the end of the last bear market. Technology stocks typically trade at a premium to the overall market, due to their outsized growth potential. With that in mind, stocks such as Facebook, Microsoft, and Alphabet have price-to-earnings (P/E) ratios less than 23x, based on estimated earnings over the next 12 months by data aggregator FactSet. These are high, but not excessive. Even stocks with very high valuations, such as Amazon, appear more reasonably-valued when using a revenue-based metric. For example, on a price/sales ratio, Amazon has the lowest ratio of any FAANG stock (Facebook, Apple, Amazon, Netflix and Alphabet's Google), and more in line with the overall market.

3. We may be seeing some early fallout from trade skirmishes.  

Earnings season is upon us and while there haven’t been many hard data points, there were a few disappointments: PPG Industries and Fastenal, two industrial companies, referenced slowing China demand. LVMH, a French luxury goods company, also noted a ramping up of border checks on returning travelers and a weaker Chinese consumer. While these are early data points, they may be pointing to a potential trend. Ford CEO James Hackett estimated a hit of about $1 billion to the automaker's profits from higher metal prices as a result of tariffs on China.

4. Earnings comparisons will become tougher.

Corporate earnings are on track to top 20% growth in the third quarter, but many companies lowered guidance for future quarters. A buoyant economy and the recent tax cuts have provided a one-time boost to earnings growth that will fade in 2019 as the stimulus wears off, according to economist Jared Franz. “By some estimates, tax cuts have boosted earnings-per-share growth by as much as 50% in 2018,” Franz says. “Therefore, earnings could decelerate in 2019, and the market is beginning to price that in.

“The dollar appreciation has also caught many by surprise,” Franz adds.  “That can be another potential headwind next year as companies in the S&P 500 Composite Index derive a significant portion of their sales from foreign markets.” 

5. Growth is slowing more than expected in China and Europe.

China’s economy in the second quarter grew at 6.7%, the slowest pace since 2016, leading to fresh stimulus measures from Chinese authorities. Europe’s economic growth rate has slowed for the third quarter in a row.

Despite a late economic cycle, some positive factors persist. China is injecting fresh monetary stimulus in the economy through an easing of credit conditions. The U.S. has seen steadily rising profit margins over the past few years, relatively low interest rates leading to low cost-of-borrowing, muted inflation in wages or commodities and reduced income taxes. These have created a positive tailwind which will diminish moving into 2019 but is unlikely to reverse. It does, however, point to more modest return expectations. 

“The market has been rising for nearly 10 years, so higher volatility at this stage should be expected,” says portfolio manager Alan Berro. “A 10% or 15% correction can happen any time for any reason. But do I expect a severe downturn, a deep recession or a global crisis coming? There is nothing I see out there today that leads me to that conclusion.”

For a full-fledged bear market to ensue, the economy needs to go into reverse. Our economists don’t expect that for some time. “We are late in this cycle but the economy is still growing strongly in the U.S.” says economist Darrell Spence. “Earnings could slow from peak levels but still remain strong by historic standards. The U.S. economy remains healthy and despite the tightening labor market, inflationary pressures appear to be relatively mild. And there are no obvious imbalances that might trigger a recession in the short term. So I expect the U.S. expansion to continue into next year.”

In volatile periods like this, investors should be sure to have a broadly diversified portfolio.

Investors should have a buffer of liquidity and sufficient diversification away from equities in their bond portfolios. Asset allocation is important and helping clients understand how to navigate this environment will be crucial. In these periods, investors can benefit from:

• Maintaining a broadly-diversified portfolio.
• Having a portion of their portfolio in liquid assets, such as cash and high-quality bonds.
• Make sure at least a portion of their fixed income allocation provides diversification from equities.
• Have a balance between growth and dividend-oriented strategies in their equity allocation.