As my colleague Rick Rieder noted in a recent post, September’s strong jobs numbers provided further evidence that the U.S. labor market and economy are recovering, and that a Federal Reserve (Fed) rate hike could be on the horizon early next year.
Rick noted what this means for the bond market; here’s my take on the two equity market implications.
More volatility. As I write in my latest weekly commentary, “The Fed in the (Market) Driver’s Seat?,” last week was marked by increasingly violent moves in equity markets. While stocks rallied on Friday, equities finished broadly lower on the week, and market volatility rose to its highest level since last March.
I expect the rocky road to continue, assuming that the recent volatility increase is at least partly being driven by expectations for normalization in monetary policy, coupled with stretched valuations in parts of the market.
Increasing divergence between market sectors. The other distinguishing characteristic of recent equity market moves is the growing divergence between market segments. Different market segments have different sensitivities to changes in monetary policy. Those segments whose valuations are more vulnerable to changing monetary conditions have been suffering lately, and their performance is likely to continue to diverge from less impacted segments.
For example, at least historically, small cap valuations have been more sensitive to changes in monetary conditions than their large-cap counterparts, and this was evident last week. While U.S. large caps, as measured by the S&P 500 Index, were never down more than 5% from their highs, U.S. small caps entered correction territory (defined as a decline of 10% or more), as measured by the Russell 2000 Index.