On Monday, Feb. 5, the US equity market experienced its first 5% drawdown in 405 days. Three days later equities reached a 10% drawdown, which hadn’t occurred in almost two years. Market participants are now processing this move in real-time. Experts stand on both sides of the spectrum – some calling for a further correction, while others advise to “buy the dip” as the move this week is being deemed to be detached from fundamentals.
So why is this happening? In our view, there is no single cause, but a confluence of circumstances and events. Crowded positioning and bullish sentiment laid the groundwork. And, while economic growth and corporate fundamentals are strong, valuations fully reflect the underlying positive conditions. Here are the key events over the past two weeks that have stirred up market volatility:
- Bond yields rose after the US Treasury announced increased bond issuance on January 31st in response to a larger budget deficit. In addition, the current administration’s announced plans for increased defense and infrastructure spending are expected to result in even more Treasuries issuance.
- Wage data released last week surprised to the upside giving rise to fears of an overheating economy in which inflationary pressures may drive central banks to tighten financial conditions further and slow the current growth cycle.
- On February 5th, the VIX index spiked 20 points which is the sharpest rise ever for the index. Many investors, especially those with strategies linked to volatility, were caught off-sides and rushed to de-risk which exacerbated the correction throughout the week.
So what now? While we think technical selling ultimately subsides in the near-term, we believe that a period of higher volatility is here to stay. Below, we address the four most important questions for macro investors looking forward.
- Growth: How is the economy doing? Amid this month’s turmoil, economic data and corporate earnings continue to surprise to the upside. Tax reform should provide a boost to the corporate sector and consumption. The synchronous global growth conditions haven’t changed.
- Policy: Are central banks tightening or easing conditions? Central banks have taken notice of the strong economy, and have increasingly adopted a tighter stance as conditions have improved. However, we do think that concerns around financial stability and increased Treasury issuance provide a counterbalance to central bank tightening. We have not yet seen a desire for policymakers to respond to recent market developments. It goes without saying that an exit from global QE will be tricky. No matter your age, no one has experienced an exit from QE of this scale.
- Valuation: What is the market’s pricing of economic conditions? Given growth conditions and policy expectations, we think valuations are key. Global equity valuations fully reflected the positive side of strong growth and a healthy corporate sector. The markets are now adjusting to the reality of balancing the downside of strong growth and the end of QE. The rates market has priced in three rate hikes for 2018, and nearly two for 2019. The market is fully expecting the Fed to reach its rate targets.
- Sentiment: What is the prevailing market psychology? Market participants were euphoric in January, and after the recent move, sentiment has reverted to a normal level. January saw the largest inflows ever into equity ETFs (+$62 billion) and February is now seeing the largest equity ETF outflow on record ($30+ billion). The American Association of Individual Investors survey signaled extremely bullish sentiment in January. This week’s report showed a drop in sentiment back to more normal levels.
Undoubtedly, we know this year will not be like the last, where virtually all markets moved higher with little volatility. We’ll continue to assess the macro developments through our framework of Growth, Policy, Valuation, and Sentiment. This framework should serve our clients well in navigating the volatility ahead.
Source: Bloomberg. This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.
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