Our Opinion: 2018

Market volatility surging

After 19 months without so much as a 5% correction, the S&P 500 fell by another 4.1% yesterday, bringing its six-day cumulative decline to almost 8%. It’s down a further 0.5% as I write this. Market volatility has surged, with the VIX index (a key measure of volatility) rising by more than 100% from 17 to 37. The yield on the 10-year Treasury bond dropped 14 basis points to 2.71%, reversing its rising trend year-to-date. But broadly speaking, US sector performance did not behave in a classic “risk-off” manner. While defensive sectors such as utilities and real estate were the top relative performers, healthcare and telecom both fell by more than the 4.1% market decline.

Unlike last Friday’s 2.1% sell-off, which was likely sparked by inflationary fears when US average hourly earnings jumped to a post-crisis high of 2.9%, there were no obvious economic triggers to yesterday’s market decline. Technical factors likely played the lead role in the continuation of selling pressure and the speed of the late-day decline. Both the deleveraging of select institutional buyers with portfolio risk limits, and the market breaching its 50-day moving average, likely accelerated the intra-day drop.

Market declines of this overall magnitude are not uncommon. Over the past 40 years, US stocks have averaged a 10.6% peak-to-trough intra-year decline during bull markets. And the positive fundamental backdrop of above-trend global growth and healthy corporate earnings remains intact. Indeed, amid the day’s sell-off, the US ISM (non-manufacturing index) rose to a stronger-than-expected 59.9 and the new-orders and employment components also rose, suggesting underlying growth momentum remains strong. Elsewhere, Japan’s services PMI rose to a three-month high, and China’s service sector PMI hit the highest level in six years.

Risks of the Federal Reserve raising interest rates too quickly and triggering a US recession over the next two years appear very low. That said, markets are likely to remain volatile in the near term. A single-day decline as sharp as yesterday’s could force further selling as some systematic strategies are forced into deleveraging, and other investors face margin calls, before longer-term investors such as pension funds begin to rebalance and buy the dip.

For private investors, portfolio diversification is always paramount. The rally in Treasury bonds reinforces the case for diversification, and holding assets uncorrelated to stocks. Investors should consider rebalancing strategies if their portfolio allocations have drifted away from their target ranges. While volatility may persist in the very near term, the bull market remains intact. This feels like forced selling due to markets taking investors by surprise, rather than investors deciding to get out.

That doesn’t mean that the stock market isn’t expensive. But at the same time, it’s not 2007 or 2008. The economy is still strong. And while the structural issues caused by low volatility punts might well have further to go, it’s not on the scale of the subprime crisis.

It’s going to be inflation that does for this bull market in the end. And that particular doom is still a little further into the future.

6th February 2018