As Economy Gathers Steam, Volatility Falls to Decades-Long Lows

By Horizon Investments

Economic data in the U.S. was generally positive last week. Some key indicators suggesting growing economic strength included:

  • Employment data was positive, with initial jobless claims and continuing jobless claims—the number of people still receiving benefits after one week—coming in better than expected.
  • Producer prices in April rose more than expected and were up strongly (2.5%) during the 12-month period through April.
  • Import prices increased more than expected in April due to rising costs for petroleum products as well as other goods.

Overseas, European industrial production, factory orders and inflation all exceeded expectations as economic momentum continues to build. In contrast, economic data from emerging markets was disappointing for the week: Brazil posted disappointing retail sales, while China’s producer price index grew at a slower-than-expected pace.

In the equity markets, shares of commodity-based companies rebounded this week fueled by higher energy prices. That move was driven in part by a larger-than-expected decline in U.S. crude oil inventories, which helped oil post its biggest one-day gain since December. The worst performing sector of the week was healthcare—and especially the biotechnology subsector—due to uncertainty over the administration’s health care policy.

In Europe, equities pulled back for the week following their large gains in the wake of the French elections. Commodity-focused emerging market countries performed well due to rising commodity prices.

In the fixed income markets, bond yields rose due to data showing stronger-than-anticipated economic growth. Long-duration Treasuries and international bonds underperformed as rates rose, while equity-focused fixed-income securities (like high-yield bonds, convertible bonds and preferred stocks) outperformed for the week.

GAIN: Active Asset Allocation

Last week was relatively quiet for global equity markets. Major U.S. and foreign stock indices were down slightly, while emerging market stocks posted gains.

Overall, growth stocks continue to outperform value shares. Technology stocks have helped drive growth shares higher, while oil price weakness has acted as a drag on value’s returns. The portfolios’ overweight to growth has been beneficial in that environment.

Interest rates rose slightly, causing Treasury prices to fall. We continue to emphasize corporate credit securities in the portfolios—a move that has benefited performance as high-yield bonds and similar credits outperformed both last week and year-to-date.

PROTECT: Risk Assist

Market volatility continued to drift lower. The CBOE Volatility Index, or VIX, traded below a level of 10 for most of last week—well below its historical average of around 20. This indicates investors do not foresee significant volatility in the S&P 500 in the coming weeks. In addition, volatility measures for other asset classes (non-U.S. stocks, Treasury rates, foreign exchange rates) also hovered at lows that have not been seen in decades.

It’s important to note that this type of calm, confident environment can lead to increased leverage in the global financial system. Strategies such as risk parity and target volatility (which are commonly used in the pension space) respond to conditions such as these by increasing their equity exposure. Likewise, value-at-risk type risk management systems allow equity traders to increase their position sizes. Rising volatility or falling equity prices could create forced selling among these strategies and market participants—which could, in turn, put additional downward pressure on stock prices in the short-term.  We would view this type of price action as a good opportunity to take advantage of forced selling.

SPEND: Real Spend

Global stocks continue to maintain a large lead in terms of performance over fixed-income securities. Meanwhile, corporate credits and high-yield bonds have outperformed Treasuries and other sectors of the bond market. Real Spend’s overweights to global stocks as well as corporate credits and high-yield bonds have therefore been beneficial.

The Producer Price Index in April beat expectations by more than 0.3%. The PPI can be seen as a leading indicator for overall inflation (CPI) because it measures manufacturing costs—the prices producers pay for their materials. These costs are often passed on to consumers in the form of higher prices for finished goods.

It’s interesting to note that many renowned investors recognize and support the importance of having an equity-focused approach to retirement income, as Real Spend does.

  • Warren Buffett on CNBC last week stated that bonds are a terrible choice versus stocks for long-term investing.
  • Larry Fink (CEO of investment management firm BlackRock) commented about six months ago that overinvesting in bonds is a huge mistake for retirees.
This article was written by Horizon Investments, a participant in the ETF Strategist Channel.

Post Comment

Do NOT follow this link or you will be banned from the site!