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No need to panic over equity market correction

No need to panic over equity market correction

06-02-2018 | Insight

There is no need to panic over the equity market correction as the underlying global economy is strong, says Robeco’s Lukas Daalder.

Speed read

  • Global equities plunge as long-awaited correction takes hold
  • Economic fundamentals remain strong and no need to panic
  • Sell-off should become a buying opportunity in the medium term

Global stocks tanked for a third day on Tuesday 6 February, having hit new records for most of last year before peaking in late January and beginning their recent slide on Friday 2 February. Of the world’s leading indices, the Dow Jones Industrial Index on Monday saw its worst one-day points drop in history, while the Stoxx Europe 600 Index hit a five-month low and the Japanese Nikkei 225 hit a 19-month low..

“We had said in our outlook for 2018 that our preferred outcome for markets was for a bit more volatility in equities and higher bond yields,” says Daalder, Chief Investment Officer of Robeco Investment Solutions. “So be careful what you wish – you might get it.”

“We had to wait until the first week of February to have our wishes fulfilled; it feels a bit unpleasant but our message is – don’t panic! One of the main characteristics of this sell-off is that it appears to be restricted to equities – normally you would expect all risky assets including high yield bonds and emerging market debt to also sell off, but losses in these asset classes have been small.”

“As such, this seems to indicate that this is much more of a technical correction, especially in stocks that were continuing to go up and up without any reason. They had become rather overbought, so at some point you are going to get a correction.”

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Strong economies

Daalder says investors should focus on the underlying economic fundamentals that remain positive for equities long term, rather than the inevitable drama that the ‘sea of red screens’ always brings. “It doesn’t feel like a life-threatening situation because the global economy is doing fine, Monday we had the ISM data which confirmed that the US economy is doing very well, with producer confidence at elevated levels of 60. Inflation gave us a bit of a scare on Friday when the data finally showed some wage pick-up. But again, be careful what you wish for… we’ve been hoping for wage inflation for years in order to stimulate the economy. So I don’t see why this should be seen as a party pooper, since it adds to the theme of de-risking and will lead to more consumption.”

“And if you look at equity futures, they’re still not pricing in any rises in interest rates beyond what was previously expected – two or three in the US – so that’s not massively negative either. So we would expect this correction to be a temporary thing; as long as the economy is doing fine, then these sell-off events are not like the market crashes that we’ve seen in the past.”

The dangers of leveraging

Daalder says some investors may only have themselves to blame if they’ve leveraged themselves – borrowed money at low rates to buy higher-yielding stocks – expecting the party to continue. “For many investors this is the first risk-off period that has been seen in a long time, and many had been leveraging on this because of the low volatility. This resulted in more and more participants in the market extending their leverage, thinking markets were only going one way, and therefore they became over-exposed.”

“However, equity markets had become too frothy and were overvalued, especially in the US. That adds to the possibility that this correction will take a bit longer to be digested by the market, and overall, there’s a reason for us to want to see this scenario play out. People should be aware of the risk out there, and if there’s no volatility and people are buying and buying while also leveraging, receiving a bit of pain is sometimes a useful reminder that the rally in equities was unbalanced and we need to rebalance it. It’s part of the normal market cycle.”

Playing in extra time?

Robeco Investment Solutions had warned that markets were ‘Playing in extra time’ in its 2018 outlook, warning that “the whistle may be about to be blown on this high-scoring game”. However, what goes up must go down – and then hopefully up again.

“We’re not at the final whistle yet – in fact, this could lead to an extension of the rally, which means there would be more upside in the longer run,” says Daalder. His multi-asset fund has been de-risking since January, expecting some sort of equity market correction to arise at some point.

“We went overweight to equities in September, mainly on account of the positive momentum at that time, and of course this momentum isn’t positive anymore, so we decided to take our chips off the table for now. This is a process we’ve been in for the past couple of weeks. With hindsight, we would have preferred to have been underweight equities, but we did make the right portfolio switches prior to this sell-off.”

“Given the unpredictable nature of what may happen over the next few weeks, we’re sitting on the sidelines for now. We’re still underweight government bonds, underweight high yield bonds, and overweight emerging market debt. And we have the express intention of entering the stock market again once things calm down a bit.”

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