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February 2018 | Toby Johnston, Global Bond Strategist; Nick Petrucelli, CFA, Multi-Asset Portfolio Manager; & Gordon Lawrence, CFA, Global Derivatives Strategist

Market volatility: Temporary spike or a fundamental shift?

We assess recent equity market turbulence from multiple perspectives and offer insights on what investors may expect next.

The recent spike in equity market volatility has rattled investors around the world. But the gyrations may simply signal that we are transitioning to the next stage in the global cycle. This shift will likely usher in a new set of macro risks and, potentially, a very different set of central bank responses.

We gathered some immediate thoughts from three of our seasoned investment professionals on what they believe caused the recent volatility, and what to look out for from here.


Toby Johnston
Global Bond Strategist

The past week has seen the return of volatility after an unusually long period of calm. Below are some of the potential drivers of the sudden change in market sentiment and my thoughts about what this may mean for the path of the US Federal Reserve (Fed).

What changed?

It is not unusual for periods of market turbulence to happen quickly, without being triggered by a significant event or catalyst. The current turbulence is a good example of how quickly the calm can turn into a storm. An accumulation of data, rather than one big event, contributed to a shift in market thinking about the risks going forward.

I think the biggest threat came from the recent tax cuts and large government spending package. It seems the markets finally woke up to the fact that the timing of the stimulus poses upside risks to inflation, Fed policy, and bond yields. This is on top of pro-growth deregulation. The old adage, “there is no such thing as a free lunch” seems especially true in this context: stimulating the economy when unemployment is low and set to fall farther still, to the lowest level seen since the 1960s.

A few data points appeared to be catalysts for markets in considering the costs of the stimulus, including a higher-than-expected core inflation result, the strongest private-sector wage result since 2008, and last Friday’s payroll report showing upward revisions to wages. Combine all that with still-sluggish productivity (despite stronger leading indicators), and we have the feel of late-cycle dynamics, with the market worried about higher interest rates and tighter liquidity as quantitative tightening (QT) takes hold.

Some of the most exotic financial instruments linked to volatility have been exposed. There is still quite a bit we don’t know about the financial plumbing of these instruments, including counterparty risk. Bloomberg estimates that around US$8 billion of these inverse VIX-style products have been created. Some are blaming the implosion of these structures as a reason for the financial turbulence. But while they probably have exaggerated the market movements, I think they are a symptom of the bigger fundamental shifts mentioned earlier.

Could recent volatility be attributed to a realization that in a full-employment economy, profit margins may come under pressure

Unit labor costs have started to rise, spelling headwinds for profits. The wage increase has recently started to outpace productivity, and while our medium-term leading indicators on productivity are favorable, the data is still showing that productivity trends remain sluggish despite some improvement off the lows. With a flattening yield curve and significant skilled labor shortages, the outlook for profit margins appears to be deteriorating, which may be another factor troubling the stock market.

Is this just a spike in volatility or are we transitioning to a higher-volatility regime?

This is an important question that is difficult to answer ex ante. What evidence do we have that the regime has changed? The data that suggests we are in a different regime includes the shape of the US yield curve and the slowdown in global central bank asset purchases, or QT. Both of these indicators point to tightening liquidity that would suggest a more difficult risk environment going forward. The lags are long and variable, however, and the message from this data remains a more difficult medium-term risk environment. Has that started now? Maybe.

Two signals that I think counter that argument: extremely low levels of global real policy rates and bloated central bank balance sheets. In particular, global real policy rate levels suggest that there is some modest tightening, but that the current rise in volatility is likely more of an overshoot spike than a big trend change. So the battle between these different signals remains unresolved. Time will tell.

How will the Fed respond?

Remember, the Fed is tightening because it wants to slow down the rapid pace of labor-market growth to avoid the need for more abrupt and recessionary-inducing monetary tightening later. Tighter financial conditions are the bridge between tighter Fed policy and its slower-growth goal. But it is always the speed of adjustments that worries central bankers, and this financial-condition tightening will be getting some attention as Federal Open Market Committee (FOMC) members seek to understand if this is something systemic, or just a “healthy” correction in an overheated market. As of today, I suspect they are viewing this as a long overdue correction rather than a systemic, cycle-killing shock.

In the run-up to the first rate hike in 2015, the Fed was faced with financial turbulence that August. At that juncture, the Fed delayed a widely expected hike as it digested market weakness, which at that time was driven primarily by worries after a sharp drop in the Chinese currency. By December, the Fed went ahead and tightened, even though financial conditions had already tightened over the prior three months. In the weeks that followed that first hike, financial conditions tightened even further, prompting the bank to delay the next hike until December 2016. That stop/start approach was understandable, given the proximity to the zero lower bound on rates, and the fact that there was still more slack to be absorbed.

Viewing the current situation, there are some important differences which I think suggest that the hurdle to pause in March is higher than in prior episodes of market weakness. First, there is less slack available now: We are seeing signs of a pickup in wage growth, and core inflation seems to be returning to the Fed’s target. Second, the economy is growing well above trend and will need to digest more fiscal stimulus this year; meanwhile, the lack of productivity is keeping trend growth stuck in low gear. Finally, the weakness in equity markets so far hasn’t spilled over as dramatically into credit markets, and the bond market isn’t seeing yields collapse.

For now, I think the Fed would probably view this as an overdue reality check for a hot equity market with limited damage to its outlook. Obviously things can change, and if we start to see much broader and more persistent risk aversion, then the bank may become more cautious as it awaits further information. But the FOMC also needs to be careful not to fall victim to the circularity trap that has delayed tightening in the last few years. Remember, tightening financial conditions is necessary for the Fed to slow the economy. In my view, it is no good if the central bankers freak out every time that process starts and abort or delay their tightening strategy. That typically just encourages more financial imbalances.

Equity market view

Nick Petrucelli, CFA
Multi-Asset Portfolio Manager

My general playbook with the recent sell-off has been to 1) add pro-cyclical risk on the margin, 2) expect contrarian trading to pay off in the short term as markets are likely to be choppy, and 3) be open to the possibility that this volatility may signal a broader shift in the market trend, rather than be the result of technical factors.

In my view, a good rule of thumb is that if a correction hits 10% and we aren’t in or near recession, and credit spreads are tight, then it can generally pay to consider buying stocks with a three- to six-month horizon. We hit a 10% correction last week and cash spreads have barely moved on investment-grade bonds.

This correction also occurred without any change to the earnings outlook (revisions actually increased recently), leaving forward price-to-earnings (P/E) ratios at their lowest since early 2016. On top of that, we’re now sitting on the 200-day moving average, which could potentially provide some support. In light of these inputs, we have marginally added some cyclical risk. However, even if markets do stabilize, I still think it makes sense to be fairly conservatively positioned, and to take time before making bigger bets.

My reasons for this stance include the following:

  1. This is uncharted territory. By many measures, we experienced a period of the lowest-ever volatility leading up to this correction, followed by what was arguably one of the fastest 10% corrections from a peak. That all makes cautious to rely too much on rules of thumb.
  2. On any normalized basis, valuations look very high. Valuation drivers seem to be heading in the wrong direction, potentially preventing valuations from returning to the recent highs.
    • Rates, including real rates most recently, have been rising.
    • Many investors are starting to shift their focus from high earnings-per-share (EPS) growth in 2018 (driven by one-off tax benefits), toward considering what happens in 2019.
    • I think that a path toward falling income margins and recession is becoming more plausible (mostly driven by higher wage costs, inflation, and tighter policy).
    • Volatility alone can change how market participants view equity risk. I wouldn’t downplay the psychological impact of this.
  3. Sentiment was clearly very excessive heading into this correction. Some of the fastest-moving signals have shifted, but I think backing off that sentiment will take time.
  4. While sharp sell-offs can seem like signs of capitulation, it isn’t clear to me that market panic has set in. Rather, the market seems to be complacent, eager to “buy the dips.” It’s worth keeping in mind that historically, the market often turns before the fundamental turn appears obvious.
  5. Typically, these sell-offs end with some loosening in monetary policy. So far, a slew of Fed officials have downplayed the significance of this correction, given the high level of equities and bubbly behavior prior to it.

Here’s what I’m looking at before making a stronger call in either direction:

  • A changing price trend. This could take some time to play out. I don’t think investors need to rush to make big changes unless they are strongly exposed in either direction.
  • Inflation data. Inflation fears, which I considered to be the biggest risk heading into this year, have risen. While my base case is higher inflation, we don’t have hard evidence yet. A miss with core inflation data could be a catalyst for a rally. In general, inflation and wage trends should be very important from here.
  • Fed shifts. Any sign the Fed is changing its tune would be a bullish signal.
  • A sellable rally. Even if this is a change in the market trend, there will likely be better tactical times to position negatively, given that market tops are a process.
  • Evidence of capitulation. This, along with a wholesale change in sentiment, would typically occur before a medium-term bottom is made.

Market flows and positioning

Gordon Lawrence, CFA
Global Derivatives Strategist

On the heels of last week’s market correction, here are a few things I’ve noticed in the markets.

Signs that some of the extended positioning in hedge funds has begun to normalize

For some time, aggregate-positioning data from prime brokers and our own empirical estimates of net-long exposure in equity long/short hedge funds have indicated a net-long bias near historical highs. Toward the end of last week, I saw our empirical estimate of that exposure decline sharply. A quick, informal poll of our prime-broker contacts confirmed this analysis; they generally reported reductions in both net and gross exposure among their hedge fund clients. Overall, we think this may suggest that risk has been cut and the need for further derisking may be smaller going forward.

Recognition that incremental selling from systematic strategies declines in the near term

Insurance products that seek to produce a targeted level of volatility in their return streams tend to add equity exposure when realized volatility in the market is low and may reduce exposure when it rises. During the recent protracted period of low volatility, many of these strategies carried leveraged equity exposures (typically 10% annualized) in order to reach their target-volatility levels. The sharp increase in volatility meant that many of these approaches needed to sell some of that equity exposure, adding substantial supply to the market. Based on my understanding of these strategies’ behavior, most of the significant sales should have taken place by now, as many have resized allocations to reflect the more-volatile environment. If realized volatility remains elevated, I think strategies will have to sell more equity exposure, but with some exposure reduced already, I believe the incremental supply should be far less meaningful.

Signs of capitulation in the options market

Based on historical data, during periods of market stress, the S&P 500 (SPX) volatility term-structure (the spread between one-month and 12-month implied volatility) tends to get “inverted,” with one-month implied volatility expectations trading above 12-month. This typically occurs because market participants can become concerned or even panicked about the short-term path of the market. Historically, an inversion between five and 10 volatility points has represented extreme pessimism and has typically presaged a rebound in markets. During the day on Friday, February 9, the SPX volatility term-structure became nine points inverted. While not a 2008-type level, this matched the degree of inversion reached during 2011 and exceeded the peak of fear for every other drawdown we’ve experienced since then.

I’m still somewhat cautious about reading too much into these signals, as the recent implosion of short-volatility exchange-traded products (ETPs) has put equity volatility squarely at the center of this event. Increasingly, however, I see signs of order returning to the volatility markets, as bid-offer spreads have narrowed from the abnormal levels that presided early last week. As a result, I’m a bit more willing to see these movements as signals rather than noise.

Views expressed are those of the authors as of 12 February 2018. Views are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. Actual results may vary, perhaps significantly, from any forward looking statements made. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.


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