The S&P 500 fell 3.8% on 8 February, bringing the index officially into "correction" territory: The index is now down 10.2% from its 26 January all-time high.
Like Monday's sell-off, we believe the latest move lower was initially triggered by "growing pains" as investors digest the implications of above-trend economic growth for central bank policy and inflation. It is notable that the 10-year US Treasury yield swiftly regained its highs this week after Monday's fall, suggesting that residual concerns about higher inflation, first triggered by the 2 February US jobs report, persist.
Inflation concerns have been further fueled, to a degree, by the US Congress's proposed budget agreement, which includes higher government spending that equates to 0.5% of GDP. This could provide as much short-term stimulus as tax reform, and has added to uncertainty around the inflation outlook. And with Jay Powell only assuming leadership of the Federal Reserve on Monday, the transition is contributing to market uncertainty over the future stance of the Fed, even if we ultimately expect a Powell-led Fed to continue the central bank's existing policies.
Technical factors also appear to have played an important role in driving the ferocity of the sell-off. As we communicated in our CIO Note earlier in the week, very sharp drawdowns can often trigger further selling, as some systematic strategies are forced into adjusting their exposure, while other investors face margin calls.
Amid all of this, the good news is that the fundamental outlook for the economy remains unchanged, and positive. There has also been little evidence of contagion from equities to other asset classes, or to the real economy. Rates, foreign exchange, and credit markets have all remained relatively calm, in spite of the multi-year high equity volatility.
We should also note that moves of this overall magnitude are not uncommon, even if the speed of this week's drawdown has been surprising. Prior to the current drawdown, there have been 23 "bull market corrections" (market drawdowns of 10–20%) since 1940.
Ultimately, with economic and profit growth still strong, we would expect to see longer-term investors eventually buying in, and providing support to the market. But it could take time for that to happen, and, in the near term, some investors may be forced to deleverage further, while others following strategies using realized volatility, correlations, and price momentum as signals, may still need to adjust their exposure.
Looking ahead, investors will likely be keenly focused on next Wednesday's US consumer price index, and Fed Chairman Powell's congressional testimony at the end of the month. The US 10-year yield will provide a market barometer on both events, and lower yields would likely be supportive of equity markets. Meanwhile, we will continue to monitor for signs of contagion from this week's equity sell-off into credit markets, which have greater potential to negatively impact the real economy.
Overall, we stay overweight global equities over our six-month investment horizon. Investors with a long-term horizon could use this opportunity to begin rebalancing portfolios after the recent drawdown, if they are able to tolerate further volatility over the weeks to come.
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