We had gone a long time with suppressed volatility, followed by markets moving rather unexpectedly this month.
After a broadly uninterrupted rise in 2017 and having started 2018 strongly, US equities saw a drawdown of over 10 per cent on the S&P 500 index and world equities of 9 per cent. The S&P 500 Volatility index (VIX) spiked from 9 at the beginning of the year to a peak of 37, having come back down substantially since then.
Market participants were focused on earnings and higher expected growth in the US driven by fiscal reform. Then a marginally higher inflation print for the end of December (1.8 per cent versus the expected 1.7 per cent expected and 1.7 per cent prior) was followed by a higher average hourly earnings number (2.9 per cent versus 2.6 per cent) in January's US employment report.
Investors quickly shifted focus to become weary of higher inflation and consequently faster tightening by the Federal Reserve and markets sold off. Stocks were stabilising when the latest US consumer price index for January came out on February 14, with core inflation at 1.8 per cent in line with the prior month’s but higher than 1.7 per cent expected. Yields on US 10-year treasuries jumped, though, equity investors seem to have taken this print and the consequent spike in US treasuries in their stride and global markets started to rebound. Though, stocks are down again globally at the market open on Tuesday 20.
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Yields on US 10-year treasuries were rising as markets started to move down, but on the first major correction on February 5 they reversed course and then started rising again. After the most recent inflation report, the market’s expectation for the rise in interest rates now seems to be close to the Fed’s path as well as its target rate. While rates are expected to rise, the path will be gradual and the neutral terminal rate - at which monetary policy is neither expansionary nor contractionary - is now lower than what it was in the past. We see rising rates, but not too high interest rates in the future.
Both technicals and fundamentals can drive market sell-offs. We believe this latest one was likely more technically driven. While concerns over inflation and rising yields can bring into question high levels of valuations, fundamentals remain strong. The magnitude and rapidity of the market correction was exacerbated by volatility targeting funds that were unwinding their positions and managers who were hedging their option positions.
Credit spreads and European peripheral spreads, which are usually good indicators of broader market stress, had seen little contagion in the first few days of the selloff. Then, both peripherals and high-yield spreads were also affected, with the latter widening 50 basis points from their lows at the end of January. Though, this move was far from the widening seen during past spikes in the VIX or past periods during which US equities were down more than 10 per cent, there might still be some catching up of credit spreads, however these have tightened again as of mid-month.
Global growth remains synchronised. In Europe, the January composite PMI came in at 58.8, the strongest expansion since June 2006, and Eurozone economic growth was 2.7 per cent in 2017, the highest since 2011. In the US, leading indicators are still green. At the end of the fourth quarter of 2017, US GDP growth was 2.6 per cent and now future forecasts have been revised higher due to the tailwind expected from tax reform. Corporate earnings growth continues to be healthy with 74 per cent of companies in the US having reported and 80 per cent beating on earnings growth. More broadly, global earnings growth expectations for 2018 continue to be strong.
This market correction may present interesting buying opportunities for investors with an appropriate time horizon and attitude to risk.
Emerging markets equities continue to look attractive. Earnings growth expectations have continued to rise since 2016 and are forecasted to be double digit this year. Valuations remain attractive especially as they are at deep discount versus developed markets based on relative price to earnings on a long-term average basis. Finally, EM fundamentals are much stronger than in the past and EM growth is now set to outpace DM growth. EM equities drew down in line with DM markets in the recent correction, though given a stronger start to the year, overall year to date their performance is higher. The trend of outperformance of EM versus DM could be set to continue.
While nothing has changed fundamentally and we do not believe this is the end of the cycle, going forward we expect a pick-up in volatility driven by higher growth and inflation. We could also see further bumps ahead and, as such, we prefer to take a cautious stance by taking the appropriate level of risk and at the same time add to attractive opportunities on a dip.
Ilaria Calabresi is a vice president at JP Morgan Private Bank