Volatility returns to the market

Thought of the day

by Mark Haefele 05 Feb 2018

US stocks suffered their biggest one-day fall since September 2016 on Friday, down 2.1%. And the VIX Index of implied volatility reached its highest level in over a year. The primary cause appears to be concerns of higher inflation and tighter central bank policy after data showed that average hourly earnings increased 2.9% in the year to January, the fastest pace since 2009.

Ten-year US Treasury yields have now climbed as high as 2.88%, a four-year high, raising the risk that borrowing costs could dampen growth. Equity market volatility spilled over into Asia and Europe on Monday, with regional indexes declining between 1% and 2.5%.

But the sharp market move should be put in context. The S&P 500 is still up 3.4% year-to-date, after its best January since 1997. Although concern about tighter policy is an important factor, stocks had already started to fall on Friday after several top technology and energy firms missed earnings estimates. And investors should remember that we are coming out of an exceptional environment. More than 400 trading days have passed since a drawdown of greater than 5% has occurred, the longest run since the 1950s.

US monetary policy is in the process of normalizing after an extended period of extraordinary and unconventional easing, and record-low bond yields. Investors should expect volatility to return to normal, too. History shows that during a bull market we should ordinarily expect five days per year with drops greater than 2%.

As long as the recent rise in bond yields moderates, we are confident that market conditions will remain orderly. So far, economic data suggests this should be the case. Inflation releases worldwide have been relatively benign. The US core Personal Consumption Expenditure Index – the Federal Reserve's favorite measure of inflation – was stable in December at 1.5%. In the Eurozone, core CPI inflation stood at just 1% for January.

With this in mind, we don’t believe that now is a time to reduce exposure to stocks. Global growth and earnings remain strong, with the recent tax cuts providing a boost to growth. We recently upgraded our global growth forecast to 4.1%, from 3.9%. Despite some high profile disappointments, the fourth-quarter earnings season in the US has surpassed expectations. Emerging markets continue to perform well. The recent weakness of the US dollar – the DXY Index is down around 3% so far this year – should keep financial conditions in emerging markets favorable.

We will go on monitoring key indicators. If bond yields continue to rise at the recent pace, inflation accelerates further, or central banks start to send more hawkish signals, we may need to revisit this outlook.

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