Investors are continuing to digest the sudden return of volatility to major stock indices around the world. For the first time in more than two years, the market has suffered a correction, with the S&P 500 down over 10% from recent highs.
This rare burst of volatility marks a sharp shift from the tranquility that has characterized much of the nearly nine-year bull-market run. The speed of the decline seems to have caught everyone by surprise, despite the consensus that such a move was overdue.
The headlines may be true, but they are misleading. While the Dow recently posted its biggest one-session sell-off on record, this would not have ranked in the top 100 declines in percentage terms.
In our view, the sell-off was a technical event and does not reflect a shift in sentiment regarding the global economy, which is experiencing broad, synchronized growth and getting stronger. And prospects for continued strong corporate earnings still make stocks attractive.
What caused the correction?
Stock markets have run up a lot since the November 2016 elections, with the S&P 500 up more than 20% last year and up over 7% in January 2018 alone. A lot of portfolio rebalancing took place at month-end, as many investors sought to lock in gains at the same time. This was starting to put pressure on markets.
At the same time, the labor report on February 2 showed wage growth of 2.9% year over year, the highest pace since 2009. Investors interpreted this as a sign that inflation may return and put pressure on the Federal Reserve to raise interest rates faster than anticipated.
Interest rates jumped to 2.85%, their highest levels in four years. Low interest rates have supported equity prices, and the back-up in yields also put pressure on stocks. It may not have been the level of rates so much as the pace at which they increased since the beginning of the year that spooked investors.
There was also a "crowded trade," with many investors betting heavily against volatility (swings in the stock market) to generate extra income. Volatility had been at a 50-year low, kept in check by low inflation, low interest rates and the expectations that these conditions would continue.
At the same time, stock prices kept moving up, and we had gone 15 months without a 3% pullback, which is very unusual by historic standards.
At the end of January, all of this started to fall apart, with investors rebalancing stocks and interest rates moving higher. Nowhere was the market's change in sentiment more glaring than in the Wall Street’s "fear gauge." The volatility index, known as the VIX, which had been trading around 10, spiked above 50, nearly doubling on Monday alone. Investors who had shorted the VIX were forced to cover, which they did by selling stocks and stock futures, which fueled the global sell-off and drove the VIX higher.
Then the machines took over. Complex algorithmic computer trading is the traditional bogeyman of stock markets, and this time is no exception. Computers that buy or sell stocks automatically can extend market optimism when stocks are booming, but also make matters worse. You have all sorts of algorithmic trading and momentum trading that compound these moves, because they tend to be trend following.
The outlook from here.
In our view, a correction like this has virtually no consequences to the global economic outlook, which continues to be strong.
There has been a drumbeat of positive economic news, including corporate tax cuts, rising wages and strong company earnings.
We expect inflation to move up slightly, but the Fed’s preferred measure of inflation, the Personal Consumption Expenditures Index, remains below their 2% target.
We expect interest rates to move higher over time but to remain low.
The real danger for stocks isn't 3% Treasury yields but a recession. If central banks maintain their slow and steady pace of rate increases, and corporate earnings remain solid, a recession soon seems unlikely.
However, we expect this pickup in volatility to continue, which could create opportunities for investors with long time horizons to "buy on the dips."
Some of this volatility is healthy, as it addresses some of the imbalances and excesses that had been building up in markets. We will be watching closely to see if this spills over into other markets and causes financial conditions to tighten. So far there is no evidence that it has, and we're optimistic it won't.
One of the things we pay close attention to is credit spreads: Both investment-grade and high-yield credit spreads are largely unchanged over the past week and trading near their historic tight levels. That suggests investors have confidence in the economy.