The late bull market and new approaches

Key takeaways

• Trade remains the biggest driver of uncertainty and the US/China dispute is getting harder to solve
• Any slowdown in US consumer spending is a potential catalyst for a market downturn
• Quantitative approaches to novel data sources are becoming mainstream but still need specialist analysis
• Sustainability criteria will continue to add value and offer the best risk-reward approach over time.

Ten years and counting since the start of the bull market in March 2009, investors are alert to any sign of the cycle spinning to a halt. This article is the fruit of the most recent event in a series of regular Lombard Odier seminars, gathering our equity investment specialists and external guests.

The adage says bull markets don’t die of old age, but fright of recession. An overheating economy, or a central bank raising rates to stifle inflation, have historically tended to kill off bull markets. For now, neither threat seems to be on the horizon. However, we can add another potential trigger; the fear that goes with uncertainty.

While it is arguable that US equity markets are currently trading at fair value, with the S&P 500 at a price-to-earnings ratio of 22 times compared with its historical average of just over 16, the danger is a volatility shock.

Around half of capital invested in US markets is in passive strategies, and/or trading on algorithms on behalf of investors who are especially sensitive to their portfolio’s risk exposure. Indeed, in this low-yield world, many investors are much more focused on balancing risk. That means any disruption to liquidity is bound to have a dramatic impact on the overall market. Liquidity in the fourth quarter of 2018 for example, fell to its lowest level in a decade, exacerbating the market’s 17% decline over the three months.

The whims of trade

What is driving investor fears? Trade is the single biggest drag on the business cycle, but a drag that is uniquely dependent on the whims of the US president’s tweets. In recent days, the situation has escalated further with reports that the US may limit capital flows into China, or the ability of Chinese companies to trade in the US.

In the meantime, the impact has not yet passed through to American consumer sentiment, which still accounts for more than three-quarters of the US economy. With the benefits of the 2018 US tax breaks on the US economy now neutralised by the US/China import tariffs, investors should remain alert to any sign of a US consumer spending slowdown, which risks tipping the economy into a wider decline. As we move into the last three months of the year, we should not let favourable year-earlier, quarter-on-quarter comparisons with late 2018 artificially inflate our understanding of the health of the underlying economy.

It is also becoming clear that the impact on Chinese trade is not what was expected. China’s exports to the rest of the world remain flat, thanks to its investments in logistics and ability to use third-party countries such as Vietnam or Cambodia, as export intermediaries. While China is suffering from rising unemployment, China’s economy has now made the transition to a mostly service-oriented economy, making it less dependent on US imports and helping to mitigate the impact of the trade dispute.