Market Uncertainty: What’s Next?

Strong economic fundamentals should ultimately drive market behavior.

The extended calm that characterized markets for the better part of a year has been shattered over the last few trading days, with the S&P 500 dropping about 6% on Friday and Monday before rebounding 1.7% on Tuesday. Global indices have been similarly volatile. In a webinar on Tuesday, four of our most senior investors (noted above) weighed in on recent market events and their implications. Here is a brief summary of their insights.

Backdrop of Strong Fundamentals

Equity turbulence comes with a backdrop of strong global fundamentals, including healthy economic growth across developed and emerging markets in 2017 and now into 2018. In the U.S., further support is coming from late-cycle fiscal stimulus. This economic momentum is driving earnings, with S&P 500 companies seeing around 17% EPS gains thus far in the fourth quarter and double-digit increases likely for the first quarter of 2018.

Correction Was Overdue

The last meaningful market correction took place in 2016, when investors were concerned about the potential for a U.S. recession, a China hard landing and low oil prices. But weakness was short-lived and markets have generally advanced since then—rising more than 40% after Brexit-related weakness (through Thursday), with unusually low volatility and no major corrections until the last few days.

Triggers—and Opportunity

The most recent pullback seems to have been triggered by last week’s 2.9% wage inflation reading and resulting fears that the Fed would accelerate interest rate increases. But the loss was exacerbated by excessive investor complacency—something that has clearly been removed over the past few days—as well as technical factors.

This removal of complacency is a healthy development, as is the reduction in equity valuations, from around 18.5 times forward earnings before Friday to some 17 today. In view of current fundamentals we see the market declines as a potential opportunity for underweighted investors to add to equity exposure.

Technical Factors at Play

In addition to the issues above, market turbulence has reportedly been made worse by trading patterns tied to the VIX Index. Over the past couple years, shorting the VIX (which measures anticipated volatility of the S&P 500) has become a popular trade. However, with the sudden surge of volatility, these investors were forced to cover their trades—buying more of the VIX and driving its price higher. The index, which was trading at around 11 two weeks ago, rose to as high as 50 and experienced a record single-day increase of 115% on Monday.

We believe volatility (now at around 30) will remain elevated for a few months, but as technical-driven aberrations continue to fade, the VIX should move to a more normal market expectation of around 20. These trends could provide more investment opportunities tied to volatility in the coming months. Keep in mind that the VIX doesn’t indicate market direction—just anticipated price movement.

Turbulence Unlikely to Affect Fed Policy

At the start of the year, we anticipated 10 trends that could affect markets in 2018. One was the potential transition from a “Goldilocks” combination of modest growth and benign inflation to something more interesting—due to growing economic momentum and central bank tightening measures. Consistent with that, growth indicators have been strong and inflation has been slightly higher than expected, which jibes well with the Fed goal of exiting a chronically low inflation environment and points to continued removal of monetary accommodation on a global basis. We have seen nothing over the past few days—volatility included—that would serve to change the current anticipated trajectory of Fed policy. Indeed, we believe the Fed is on track to increase interest rates two to four times in 2018.

Normal Credit Conditions, Upward Yield Trend

With relatively little change in the fundamental picture, we believe that price changes in credit markets have largely been a function of technical factors—equity market volatility spilling over into global credit. High yield has been modestly re-priced, but liquidity in the sector remains healthy. Investment grade deals continue to get done, and the U.S. credit markets are functioning normally. The effect on emerging market debt has been muted.

In terms of yields, we have seen a modest upward move for long-term U.S. bond rates—a trend that should continue for much of the year. However, given the global appetite for yield, we anticipate that both foreign and domestic investors will continue to exert a dampening influence on how high those bond yields can rise.

Conclusion

The current “interesting” market environment is fluid and complex. As mentioned, we do not expect an immediate resolution of market technical quirks or an end to concerns about the pace of central bank rate hikes. It is possible that market volatility could have a negative impact the real economy—undermining the so-called wealth effect and consumer confidence, and substantially widening credit spreads. However, there is little current indication that anything like that is taking place. In fact, global economies continue to show exceptional strength—something that should be a key driver of markets in the coming months.

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