Author: NN Investment Partners
Equity markets had not witnessed a meaningful correction since the beginning of 2016 and in the past few months, red lights of over-optimism and extended positioning of investors have been flashing on our dashboards. Last week’s sell-off was therefore long overdue, although we believe that fundamentally not much has changed.
Last week’s market volatility was less about the economy and more about the unwinding of extremely crowded trades, most notably a bet on low volatility.
The correction that was long overdue
First of all, let’s start with the definition of a correction: a 10% fall in prices from a recent high. Since the S&P 500 closed at a record high of 2,872 on January 26th, the index has fallen 8.8% through last Friday so theoretically we are not in correction territory at the moment. Wall Street's last correction ended in February 2016. After a long and steady uptrend, a material sell-off in equity markets was long overdue, even if the timing and magnitude were, as always, difficult to predict. During the past few months, investor positioning in risky assets had risen to multi-year highs, as illustrated, for example, by the record inflows in January in equity funds and ETFs. Investor optimism was also high, as illustrated by the low put/call ratio and the high bull/bear sentiment index earlier in the year. In addition, there was a broad-based consensus with regard to sectors (financials and cyclicals versus utilities and real estate), themes (especially short volatility!) and asset classes (equities over bonds), which reversed on Monday. Our shorter-term behavioural indicators had indeed started to hint at underlying fragility in the market for some time. These observations led us to reduce the equity exposure in early January and to maintain only a small overweight in global equities.
Exceptional moves in volatility in the US equity market
The most spectacular move was not in the cash equity market, but in implied volatility. The VIX, which captures implied volatility on the S&P500 index and is colloquially referred to as Wall Street’s fear gauge, soared from 17.3 to 37.3 last Monday, its biggest percentage move ever. The fact that the jump in the VIX was even bigger than what was seen during the market meltdown after the collapse of Lehman Brothers in 2008 underscores how exceptional this event was. In this respect it was also noteworthy that the US equity market lived through a mini-flash crash intraday on Monday as the complete market went up and down by 2%-points within 15 minutes. This is obviously not something that stems from a shifting perception of the outlook for corporate profits in the US economy. It clearly added evidence to the diagnosis that it was more a behavioural or “technical” correction.
The remarkable move in the VIX hurt one of the most prominent consensus trades of the past year: short volatility. These (leveraged) investors have really been caught by surprise and had to hedge their exposure, which exacerbated the move in the VIX. After the record inflow of January, and the large inflows in the months before, equity funds may see outflows in the coming days or weeks. This may be linked to risk-driven funds (risk parity funds) that are forced to de-risk in view of the higher market volatility. Momentum-driven investors may also reduce their equity exposure. So, the market will need some time to sweat this out and to stabilise.
The fundamental picture remains invariably strong
As often is the case, a correction needs a trigger. Quite likely, the string of slightly better inflation numbers, a slightly more hawkish reading of central bank language, in combination with strong January US wage data, have triggered last week’s sell-off. Nevertheless, we do believe that the largest part of the move in global equity markets has been technical in nature. The fundamental economic picture remains as strong as before, indicated by our global surprise indicator which even improved a bit further.
In the US, the earnings season is evolving well. More than half of the S&P500 companies have reported and about 80% have done better than expected. Earnings momentum also remains strong, with the FY2018 bottom-up estimate indicating 20% growth in earnings-per-share. Two weeks ago the consensus was almost 3 percentage points lower; a huge move even after the publication of disappointing results in the energy sector. In addition, macro data remain supportive and are generally better than expected. Witness the strength in the Eurozone PMI data or the ISM Non-Manufacturing composite and the January labour market data in the US, which might have sparked some inflation fears and raised question marks about the consensus “Goldilocks” scenario that prevailed over the past period.
Bond yields impacted by policy normalisation
Despite the strong data, especially the upside surprise in US wage growth, we do not change our central bank policy outlook. Our view is that the Fed will hike rates three times this year, followed by another two hikes in 2019. We also expect the ECB to do a “soft taper” between September and year-end before hiking policy rates the first time in Q2’2019. Having said this, we do expect that policy will become less straightforward and more data-dependent. Central banks are walking a tightrope. On the one hand, they have to anchor long-term inflation expectations, an objective that may require a moderate inflation overshoot. On the other hand, they are aware of the risks of overheating the economy and of irrational exuberance in markets by doing so. At the same time, confidence is growing that policy can normalize, which is an element that might impact the rise in bond yields and, if this rise is too rapid, risky assets as well.
Since mid-December we have seen a gradual yet convincing rise in 10-year developed market (DM) government bond yields. The graph below shows the development for Germany and the US. Both have increased clearly above the peaks of last year. This is not just limited to Germany and the US; also in other DM countries (with the exception of Japan) we have seen significant rises in 10-year yields. The rise in bond yields is chiefly driven by the expectation of monetary policy normalisation. This rise was enhanced by the strong US wage growth data of January published on Friday, which was likely one of the key triggers for the correction on Monday. The upward trend was then interrupted by the equity sell-off on Monday. The rise in the 10-year US bond yield since December is to a significant extent driven by long-term inflation expectations, while in Germany the yield increase is more driven by the real yield.