Global equity markets have fallen sharply over the last two weeks, as investors feared inflationary pressures might cause interest rates to rise more quickly than previously expected. The trigger for the initial sell-off last Friday began as a reaction to rising U.S. Treasury yields following the January jobs report, which showed a rise in U.S. wages. Stock market swings intensified this week with much of the continued selling spurred on by the programmatic trading of volatility-sensitive strategies.  

A common measure of volatility, the CBOE Volatility index (VIX), pushed above 35, more than doubling where it was a week ago. The Dow Jones Industrial Average suffered two 1,000-point day plunges, with Thursday’s decline largely due to a budget deal that will further raise the federal deficit. This caused all major domestic indexes to enter correction territory, down over 10% from their highs on January 26, 2018. U.S. stocks turned positive on Friday but were down over 5% for the week, while international markets were down by similar amounts, as jitters spread.

Although the 10-year U.S. Treasury yield has moved higher since the start of the year and hit 2.85% last Friday, the fixed income market has been relatively orderly during the equity market sell-off. The Treasury yield curve steepened with investors seeking the relative safety of high-quality, shorter-dated securities. The investment grade corporate market also has been very stable, but high yield bond spreads have understandably widened given their higher correlation to stocks. The yield on the two- and 10-year U.S. Treasury notes ended the week at 2.06 and 2.85%, respectively.

Though this sudden increase in volatility has led some to question whether the nine-year old bull market is in peril, we believe that all the relevant indicators point to this being a much overdue correction.

Markets Recalibrate

After a strong advance at the start of the year and elevated levels of optimism, equity markets were ripe for a period of consolidation. Equities had climbed higher following the tax package as economic and corporate earnings forecasts were ratcheted higher. Now, equity markets are recalibrating and adjusting to somewhat stronger growth and determining what that means for interest rates and inflation.

The recent move higher in global government bond yields is consistent with stronger growth and an expected normalization of monetary policy. However, the markets are now worried that the Fed may need to speed up its pace of interest rates hikes because of faster-than-expected inflation brought on by the potential for higher growth that resulted from the recent tax cuts. The combination of the Fed beginning to shrink its balance sheet, tax cuts and spending increases could put upward pressure on Treasury yields.

We believe, however, we are likely seeing the market shift away from its focus on disinflation rather than an elevated risk of a spike in inflation. In fact, with the backdrop of oil declining materially over the last two weeks, inflation expectations have normalized back to 2% and should only gradually move higher. While higher rates and inflation can weigh on equity market valuations, we believe equities will be supported by better earnings. We are in the midst of a strong earnings season, forecasting strong year-over-year earnings growth, which factors in a boost from U.S. tax cuts.

Keeping Markets in Perspective

While high volatility can be disconcerting, investors should be careful not to overreact. For example, take the fact that the VIX closed above 37 on Monday, February 5, 2018, one of only nine times it has closed above 35 since 1990. Of those nine occasions, three can be tied to weak market fundamentals and subsequent recessions. The other six occasions were unrelated to fundamentals — the results of sudden shocks, technical flash crashes, etc. Six months after those occasions, the market had gained 12%, on average; 12 months later, it had gained 20%.

We continue to believe that economic and earnings fundamentals remain solid and will continue to support an equity-friendly environment. That’s why this sell-off is most likely a long overdue correction rather than a sign of weakness in the economy. Investors’ portfolios are positioned well for stronger global growth, favoring a diversified mix of global equities over fixed income and incorporating assets not correlated to stocks or bonds. In light of this, we do not expect any major changes to our asset allocation — except possibly to gain exposure to asset classes that are offering a better value than they did before the pullback, such as international equities and diversifiers. The ongoing volatility is also creating some attractive bottom-up opportunities across asset classes. As an example, our large cap analysts are seeing opportunities in high-quality, blue chip stocks as well as companies that have solid competitive positions in their industries yet have fallen more than the market. Likewise, our fixed income analysts are monitoring weakness in the high yield market for possible undervalued securities.

While we may continue to see some additional market volatility, this period of consolidation should serve as an important reminder as to why we advocate rebalancing, diversification and customized hedging strategies. The underlying fundamentals of positive economic news, strong earnings and now more reasonable valuations should drive stocks higher, but the path will be more volatile than it has been in the past few years. We still believe that in 12 to 18 months, we will look back at this period as having been a better time to enter the market than to exit.

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