Global markets have suffered a frightful October, with Tuesday's tumble taking the FTSE All-World index's loss this month so far to a whopping 7.3 per cent — its worst performance since the peak of the eurozone crisis in 2012.
Of the global equity benchmark's 3,211 members, almost a third have now lost more than 20 per cent of their value this year in US dollar terms. Well over half are down at least 10 per cent, and as of the end of Tuesday, only 853 companies are still in positive territory for 2018.
Investor pain has been widespread. The only major asset classes to remain in the green this year are the equities of large US companies, and US junk bonds. Aside from those two classes, investors have suffered losses in almost every major corner of financial markets in 2018. And even the S&P 500 and the Bank of America junk bond index are now up just over 2 per cent for the year.
Behind this development is a complex tangle of factors that have unnerved investors.
October may have started with investors worried about climbing US interest rates and bond yields, but as the month draws to an end it is a good old-fashioned growth scare that is primarily worrying investors.
Citi's global economic surprise index — which measures how often data comes in better or worse than expected — has been in negative territory since April. That is the longest sub-zero stretch in four years. Signs of fading economic momentum led the International Monetary Fund to knock 0.2 percentage points off its forecasts for global growth in 2018 and 2019, to 3.7 per cent in both years.
Markets are signalling that the slowdown may be even more severe. The global materials sector has fallen more than 20 per cent since its January peak, the typical definition of being in a bear market. Other growth-sensitive, cyclical corners of the stock market — such as asset managers — have also suffered steep falls lately.
While the European economy has stalled somewhat, the biggest current cause of the global growth scare is China.
The Chinese economy has been gradually slowing since 2014, as the authorities try to engineer a soft economic landing after a long construction-driven, debt-fuelled growth spurt, and a pivot towards a more consumption-led model. But Beijing reported last week that the pace of economic expansion slowed to 6.5 per cent in the third quarter, undershooting expectations and marking the slowest reading since the 2009 post-crisis nadir.
Together with the impact of the trade war with the US, that has sent the mainland CSI 300 index down 21 per cent this year, and Hong Kong's Hang Seng (.HSI) benchmark by 15.3 per cent. The heavily managed renminbi is down about 10 per cent against the US currency, and is once again flirting with the 7-per-dollar level last seen in early 2008.
Standard Chartered's economist recently visited China, and reported to clients this week that "sentiment on the ground is weak".
"Increasing cases of debt defaults, failed land auctions and bailouts of listed companies are symptoms of more deep-rooted problems, according to the experts we spoke to," the bank said in a report. "Trade tensions with the US, which are expected to drag on, make it more difficult to address domestic weaknesses such as overcapacity and high leverage."
Investors are mulling the growing stand-off between the Italian government and the EU over public spending, as echoes of the Greek debt crisis grow louder.
The populist coalition governing the eurozone's third-largest economy — and its most indebted member — has taken an explicitly Eurosceptic stance and is planning to hike public spending at a time when the European Commission says it needs to cut back.
With credit rating agencies' disapproval growing louder, Italian bond prices are sliding, posing a challenge to Italy's banks — which are one of the biggest holders of its sovereign debt. Bond price falls feed through into banks' balance sheets and back into the bond market in a process dubbed the "doom loop".
Some analysts estimate that a 4 per cent yield on the 10-year bond is the critical threshold above which Italy's debt becomes unsustainable from a fiscal perspective. It is currently trading at around 3.59 per cent, after jumping another 10 basis points on Tuesday. Rome has said that it will take action of some kind if the 10-year's spread over German Bunds hits 400bp; it is currently at 318bp.
Unlike the rest of the world, the US economy still looks in good shape. However, investors are beginning to fret that the corporate earnings growth seen earlier this year is as good as it will get, given rising wage costs, interest bills and materials prices. Moreover, the impact of the 2018 tax cut will make this year's results hard to beat in 2019.
"The discussion in investment committee meetings and with investors is: have we hit peak earnings and have we hit peak valuations?" said Michael Underhill, chief investment officer at Capital Innovations.
The third-quarter results of 3M (MMM) and Caterpillar (CAT), two US industrial bellwethers that reported on Tuesday, fed this concern. 3M cut its earnings forecasts. While Caterpillar's profits beat forecasts, its warnings of rising materials costs rattled investors. Both sets of results fed into the emerging "peak earnings" narrative.
"You have the Fed raising interest rates, rising input costs, a tight labour market and tariff pressures — that is a peak earnings story," said Jason Browne, chief investment strategist at FundX, an investment advisory and money manager.
Although corporate profits are still largely expected to grow at a healthy clip, Bank of America analysts note that the stock price reward for beating forecasts faded sharply in the second quarter. This earnings season, companies have tended to fall back despite slim earnings beats — for the first time since at least 2000. That is one of Bank of America's "bear market signposts".
The US may have reached a new trade agreement with Mexico and Canada to replace the Nafta deal reviled by President Donald Trump, but Washington remains at loggerheads with China, slapping $250bn of tariffs on Chinese goods and demanding sweeping changes to the country's economic policies.
After occasional hints of a thaw, the imbroglio appears to have reached an impasse. If there is no progress in the coming weeks, the Trump administration is expected to introduce another $200bn worth of tariffs — perhaps sanctioning all Chinese imports.
This could knock both the US and Chinese markets, as well as many European companies that are tied into the global supply chains.
Rising interest rates
Bond markets rallied on Tuesday as the stock market turmoil sent investors heading for the relative safety of highly rated government debt, such as US Treasuries, German Bunds and UK gilts. However, investors remain on edge about the impact of rising interest rates on both fixed-income and equity markets.
The Federal Reserve is expected to lift rates for a fourth time this year in December, and is slowly but surely shrinking its balance sheet, which has been stuffed with bonds acquired when combating the financial crisis. The European Central Bank plans to end its own bond-buying by the end of the year, and even the Bank of Japan is easing back on its monetary pedal.
The net effect of this is what investors have dubbed "quantitative tightening", a sea change in the global monetary environment since the financial crisis that some fear bodes ill for markets in 2019.
All these economic developments and market movements are playing out against a backdrop of a murky political climate.
Some investors are now beginning to eye the US midterm elections on November 6 with trepidation. Prediction markets indicate the Democrats will gain control of the House of Representatives, while the Republicans retain a slim majority in the Senate.
A Democratic sweep, however, could ramp up the risks of a presidential impeachment and imperil the Republican party's spending plans. On the other hand, a Republican victory in both houses could lead to another deficit-busting tax cut.
But with a divided government a possibility, the most likely consequence "would be an increase in investigations and uncertainty surrounding fiscal deadlines, which could raise equity volatility", Goldman Sachs said in a note to clients.