Views From the Floor

In this week’s edition – Apocalypse Later? Why October wasn’t the end of the cycle; and the Fat Tails from nowhere.

Apocalypse Later? Why October Wasn’t the End of the Cycle

It was a tough October for equity markets. The S&P 500 declined 7%, the Nasdaq 9.2 %, the FTSE 100 5.1%, the Eurostoxx 50 5.9%, the Hang Seng 10.1%, the Shanghai CSI 300 8.3% and the Nikkei 9.1%.

But investors should remember that an equity market correction is not necessarily the same as cycle culmination. We don’t think a recession is imminent, especially not in the US. Here are five charts which show why.

1. US Unemployment and Participation Rates

As of October 2018, the US unemployment rate stood at 3.7%, a 49-year low. In addition, participation rates have held steady at about 63%. Given America’s aging population, this is an important metric to look at as older people tend to work less. The US participation rate has now nudged ahead of where it would be modelled using UN demographic forecasts. It’s early days but if this continues, there will be more slack in the labour market than is expected and an inflationary end to the cycle could be pushed further out.

Figure 1. US Unemployment Rates at 49-Year Lows, Participation Rates Steady

US Unemployment Rates at 49-Year Lows, Participation Rates Steady

As of October 2018.

2. US Wages

As of October 2018, year-on-year growth in hourly average earnings stood at 3.1%, accelerating from a rate of 2.8% the month before. Admittedly, there is a base effect here given the impact of hurricanes in October 2017, but an optical uptrend still seems clear. While this does have implications for corporate margins, wage growth increases the disposable income available to the consumer and could have positive implications for future demand.

Figure 2. Growth of US Average Hourly Earnings (Year on Year)

Growth of US Average Hourly Earnings (Year on Year)

As of October 2018.

3. Initial Jobless Claims

US initial jobless claims have consistently risen into recessions, as shown in Figure 3. As ofat the end of October, the number of Americans filing for unemployment benefits had decreased to 214,000, the lowest level since the 1970s.

Figure 3. US Initial Jobless Claims Are on a Downward Trend

US Initial Jobless Claims Are on a Downward Trend

As of October 27, 2018.

4. Manufacturing PMIs

Now, the first three charts are all lagging indicators. It is true that manufacturing PMIs, perhaps the most reliable mainstream leading indicators, are rolling over. However, as can be seen from Figure 4, the US manufacturing PMI remains at multi-year highs, while Europe, though declining, is still two points above the 50 contraction/expansion threshold. We tend not to worry too much about the direction of the indicator: in our experience, it is better used as a binary above-/below-50 measure. We are, however, keeping a close eye on China, which is only marginally above this threshold.

Figure 4. Manufacturing PMIs for US, Eurozone and China

Manufacturing PMIs for US, Eurozone and China

Source: Bloomberg, Haver; as of October 2018.

5. Manufacturing PMIs (New Orders)

Drilling into the PMI, the most useful component is New Orders. Here we would introduce a note of caution. Both have dropped sharply and the Eurozone is now below 50. While we are watching this closely we do not think this yet heralds imminent recession. We note that the Eurozone number has been affected by the introduction of the Worldwide Light Vehicle Test Procedure (WLTP). The new regulation requires all vehicles to be tested for emissions in real world scenarios which has created an inventory overhang for the German auto industry. This largely explains the drop – Germany’s October 2018 incoming auto orders were down 8% from last year’s level1 . So while we always pay attention to a New Orders reading below 50, we do think there are technical factors at play here which may not necessarily be repeated. We don’t think this represents sufficient evidence to counteract our prior points.

Figure 5. Manufacturing PMIs (New Orders)

Manufacturing PMIs (New Orders)

Source: Bloomberg, Haver; as of November 6, 2018.

Dividend Yield – Back to Basics

After a difficult month for equities, it is worth re-visiting tried and tested methods to see what wisdom they hold for long-term investors.

One such method is looking for stocks with a dividend yield above their price-to-earnings (‘PE’) ratio. These stocks tended to generate outperformance in subsequent periods. Between 1985 and 2009, they returned an average of 28% on a total return basis over the 24 months after the dividend yield went above their PE. However, we found that only 60% of stocks bought when dividend yield was above PE showed a positive return over the same period. Clearly, returns from winners far outstripped losses from losers, which we would argue is due to losers being cheaper in the first place. We believe that this relationship still holds true today. As of November 6, 2018, the FTSE All Share Index showed 22 companies whose dividend yield exceeded their PE ratios. As such, for investors with a long-term horizon, we believe there may be value available, even in volatile markets.

As of November 6, 2018, the FTSE All Share Index showed 22 companies whose dividend yield exceeded their PE ratios. As such, for investors with a long-term horizon, we believe there may be value available, even in volatile markets.

Figure 6. Stocks With a Dividend Yield Greater Than Their PE, FTSE All Share Index

Stocks With a Dividend Yield Greater Than Their PE, FTSE All Share Index

Note: The numbers above denote the number of companies whose dividend yield exceeded their PE ratios. Source: Man Group, Bloomberg; as of November 6, 2018.

The Fat Tails From Nowhere

Despite the Nasdaq being up 9.15% this year to November 7, realised volatility has had several significant spikes during the year. Since the end of the financial crisis in 2009, Nasdaq 10-day realised volatility has broken through 40 only six times — three of these occurrences have been in 2018 alone!

These sharp leaps in realised volatility stand in stark contrast to earnings and economic data, which appear quite robust in the US. In both February and October of this year, the dramatic lift in volatility came from low levels. (Indeed, as we mentioned in our article ‘Portfolio Hedging: Targeting Risk, Not Returns’ Portfolio Hedging: Targeting Risk, Not Returns, the February spike in the VIX was a bit more unusual: if the distribution from which it was drawn is assumed to be normal, the implied frequency of the move that occurred on February 5 is closer to once in 300 quintillion years2 .)

As a result, risk-management tools based on much lower levels of volatility may have dramatically underestimated the size and severity of the shock to profit and loss (‘P/L’) in October. Even as net exposures came down through October, high gross exposures left funds exposed to higher P/L volatility, leading to a larger de-risking toward the end of the month.

Figure 7. Spikes in Realised Volatility in the Nasdaq

Spikes in Realised Volatility in the Nasdaq

As of November 7, 2018.

Pharma Bounce?

We believe the pharmaceutical sector could recover in the next few months, driven by two factors: the outcomes of the US midterm elections; and the level of M&A.

With regards to the US midterms, the outcome is a relief for the pharmaceutical sector. President Donald Trump does make a lot of noise about the drug prices, but the market generally seems ok with that.

On the M&A front, activity in the pharmaceutical sector has been at its lowest point for about six years, according to our calculations. With the midterms uncertainty out of the way, we may see the emergence of M&A activity, especially in biotech names, which could provide a boost.

With contribution from: Ben Funnell (Man Solutions, Portfolio Manager), Teun Draaisma (Man Solutions, Portfolio Manager), Henry Neville (Man Solutions, Analyst), Henry Dixon (Man GLG, Portfolio Manager), Peter van Dooijewert (Man Solutions, Head of Institutional Hedging) and Graham Stafford (Man GLG, Portfolio Manager).

1 https://www.vda.de/en/press/press-releases/20181102-german-car-market-still-feels-october-pinch-from-switch-to-wltp.html

2JPM Derivatives Research