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Reflections on a Red October

November 2018
By Nanette Abuhoff Jacobson

October's 7% market drop was the worst one-month decline since 2011.

 


 

Lots of questions have swirled around the horrible performance of risk assets in October. Have corporate earnings peaked? Are markets adjusting to higher interest rates? Was this an overdue correction? I think the answers are yes, yes, and yes.

In my view, the market is calibrating specifically to three things:

  1. The slowdown in the pace of global growth, which could start to show up in weaker earnings; 
  2. The 0.40% rise in 10-year US Treasury yields between the end of August and beginning of October; and 
  3. Overbought conditions in cyclical sectors, particularly technology.

I maintain that the economic slowdown is modest and starting from healthy levels. Recession risk remains low, so there is little need for investors to panic. That said, recent sector performance may give us some important clues about the future.

FIGURE 1 shows the bifurcated performance of cyclical and defensive sectors over the past two months. Consumer discretionary, industrials, and information technology—all cyclical sectors—performed the worst relative to defensive areas, such as consumer staples and utilities.

 

Figure 1: Bifurcated sector performance

MSCI USA Index1 sector performance, US 10-year Treasury  yield, indexed to 100 on 9/28/18

As of October 31, 2018 | Source: Bloomberg | Past performance is not guarantee of future results. Investors cannot directly invest in an index. 

Curiously, the outperformance of defensive sectors occurred despite the rise in 10-year yields that began in late August. This seems counterintuitive given that these sectors are often considered bond proxies because of their typically steady cash flows and relatively high dividends.

My take on this dynamic is that the market isn’t just concerned with higher interest rates; it is also worried about—and starting to price in—slowing global growth. Investors may have sold cyclicals, which have performed well in recent quarters and appear overbought, in anticipation of that trend. I think it is prudent to consider reducing equity risk at this point by rotating into more defensive sectors.

Investment Implications 

Consider maintaining an overweight to equities relative to bonds, but focus equity exposure in less risky regions, such as the US, over other developed markets and emerging markets.

Within cyclicals, consider thinking about rotating away from expensive areas, such as consumer discretionary, industrials, and IT, into cheaper areas, including financials and energy.

Consider adding defensive sectors, such as consumer staples, healthcare, and utilities, that could potentially outperform in a lower-growth environment.

Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.

1 MMSCI USA Index is a free float-adjusted market capitalization index that is designed to measure the performance of the large and mid cap segments of the US market.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Focusing on investments in particular sectors may increase its volatility and risk of loss if adverse developments occur. • U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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