Tough week ends with a Friday rally

Thought of the day

by Chief Investment Office 12 Feb 2018

What happened?

The S&P 500 rose 1.4% on Friday, but finished last week down 5.2%. At its intraday low, the S&P 500 was down nearly 2% on Friday. But unlike the trading pattern for most days during the past two-week correction, stocks rallied sharply in the final hour of trading. The 10-year Treasury bond yield rose three basis points on Friday to 2.85%, finishing the week largely unchanged. Interestingly, despite the sharp decline in stocks, the US yield curve steepened eight basis points last week and has steepened 25 basis points since the beginning of the year.

What triggered it?

As discussed during the week, we believe that the equity market sell-off over the past several days was driven by a combination of technical factors and fears of a pickup in inflation. Some estimates suggest that systematic trading strategies saw weekly selling of USD 100bn, contributing to the extreme market volatility. More fundamentally, economic data – both in the US and globally – remains robust. But investors fear a pickup in inflation may push interest rates even higher, potentially derailing the expansion and/or denting equity market valuations. The US budget agreement adding USD 500bn to the deficit over the next two years, a new chairman at the Fed, and the continuation of the Fed reducing its balance sheet further clouds investor perception over the interest rate outlook.

What are the key takeaways?

Despite the recent US and global equity market downdraft, we believe that the bull market remains intact. While market volatility may have rattled some investors, we do not expect the magnitude of the losses to date to have any material impact on the real economy. Keep in mind that US stocks are still up 7% and 16% respectively over the past six and 12-month periods.

Fourth quarter earnings season is winding down, and results show positive momentum heading into 2018. Earnings rose 15% year-over-year on 7% sales growth. The consensus 2018 S&P 500 EPS estimate has increased by USD 10, or 7% since the beginning of the year to USD 157. At Friday's close, the price to earnings ratio for US stocks has declined to 16.7x this year's earnings after peaking near 19x in late January.

European earnings also remain robust. With roughly half of the Stoxx 600 having reported, EPS growth is on track to be up 16%, with cyclical sectors such as technology and consumer discretionary leading the way. Asian earnings should come within striking distance of the consensus 13–14% EPS forecasts for this year, backed by strength in IT growth stocks, better margins for cyclicals, and improving asset quality at banks.

Finally, investors should recognize that equity market drawdowns during bull markets are fairly common, and often do not portend a bear market. In fact, US stocks have seen 23 "bull market corrections" (declines over 10%, but less than 20%) since 1940, and forward-looking returns following such episodes have been well above-average.

Near-term markets are likely to remain volatile, but the peak in volatility is likely behind us. While this does not mean that stocks have necessarily bottomed in the short term, we stay overweight global equities over our six-month investment horizon. Rising interest rates are coinciding with strong global earnings momentum and positive forward-looking revisions. Stabilizing bond yields and sustained economic growth should allow stocks to regain their footing over time.

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