Real estate and spread products like emerging market debt and high yield also corrected, but less dramatically than in earlier risk-off phases in the year. A key reason was probably that bond yields actually fell, while their previous rise had been a headwind for other fixed income segments and EM assets.
With the benefit of hindsight, multiple reasons can be found for this correction. The rise in interest rates over the previous weeks, disappointing data releases or fading earnings expectations might have played a role. Other contributing factors include a further deteriorating trade relationship between the US and China, and additional confirmation that the Italian government has started to work based on unsustainable budget and growth targets. Rising concern over geopolitical risks is certainly something that has also become visible on our digital sentiment radar as the opinions in financial news and social media on trade conflicts, tensions between Italy and the EU and the rise of populism in Latam (read Brazil) have turned much more negative (see Figure 1). Meanwhile, Brexit news has been getting a lot of attention, but the sentiment around this in terms of potential market impact is fairly modest (as evidenced by the evolution of the light blue line).
However, none of these factors was a clear trigger for the sharp shift in risk appetite that emerged in the middle of last week in the US equity market. At a certain unpredictable point in time these factors might have interacted to tip the market crowd into a new perspective
on our economic future. Given that we had also become more cautious on the outlook for risky assets at the beginning of last week, this appears to be a reasonable scenario. Indeed, we were probably not the only investor noting a combination of market drivers that had become a bit more uncertain in recent weeks.
Or, we might have been right for the wrong reasons. In a complex system like the market ecology in which we operate, a coincidental combination of investor behaviours can easily create a tailspin in markets with a clear link to underlying economic fundamentals. Every self-critical investor knows that being on the right side of a trade does not automatically mean you got the analysis right.
Part of our analysis was also based on more behavioural dynamics like investor sentiment, positioning, short-selling, the evolution of liquidity conditions and herding of investors. While this last component was still visible in the US equity market, it had already started to fade in many other risky assets. Moreover, many of the other behavioural metrics had started to weaken in recent weeks. Again, this is not something that reveals the timing of the next market correction, but an important insight into the underlying fragility of the market environment.
Now that we have seen the most serious correction in global equities since February, the next question is what to do next. If this is indeed a correction and not the beginning of a bear market, then close monitoring is needed to determine when more defensive positioning should be unwound. But if this proves to be the beginning of a more serious slowdown in the global economy on the back of an escalating trade war and further tightening of financial conditions, then we have seen nothing yet. At this point we are more in the “correction” camp, but also feel that the fragile market backdrop might last a bit longer. Our eyes are open to identify new entry opportunities over the coming months, while our minds remain open to the possibility that our base case scenario will have to be adapted downwards. An open perspective and an adaptive approach may be the most valuable assets to hold for any investor in these times of change.
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