February 8, 2018

What’s Behind the U.S. Market Turmoil?

by Tajinder Dhillon

Earlier this week we saw how quickly markets can escalate a viewpoint and create a snowball effect, for better or worse.  On Feb. 5, the latter occurred where global equity markets suffered their worst one-day performance in years due to growing concerns of inflation and monetary tightening.

Let’s recap these events and some of the reasons behind them, with a focus on the U.S.  Much of what has been published about the sell-off should be balanced against a strong economic backdrop and robust earnings growth.

So, it was well documented that the S&P 500 suffered its worst one-day sell-off since August 2011. I decided to look at how the decline ranked over the last 20 years for both the Dow Jones and S&P 500 and the results were noteworthy.  We can see in Exhibit 1 that the Dow Jones and S&P 500 experienced their 19th and 30th largest 1-day drop (excluding intraday movements).

For the curious – the number of times that the Dow Jones and S&P 500 has experienced a one-day drop of more than 4% over the last 20 years has been 29 and 31 times, respectively.

Exhibit 1: Worst one-day sell-offs over last 20 years

Source: Thomson Reuters Eikon/Datastream

The sell-off’s partner: volatility

In my last post, I mentioned keeping an eye on volatility and this certainly did not disappoint. VIX reached an intra-day high of 50, a level not seen for almost 10 years (VIX reached 25 on the day of Brexit). If we extend our analysis outside of the U.S., volatility index levels YTD have increased 80%, 82%, and 93% when looking at the Euro Stoxx, FTSE 100, and Nikkei 225. One interesting result from all this was that Credit Suisse, who offers the second-largest low-volatility ETF, liquidated its fund after tumbling more than 90%.

One factor that is contributing to inflation concerns is U.S. wage growth, which reached a 10-year high of 2.9%. Coupled with robust employment levels, there is added concern that the U.S. Federal Reserve will have to step in and perhaps raise rates more than the expected three times in 2018, or raise rates more quickly than expected. We could expect sustained higher wage growth eventually to squeeze corporate profit margins.

Exhibit 2: U.S. Wage Growth at a 10-year high

Watch inflation

U.S. inflation has been hovering at the 2% mark since August 2017 and when looking at inflation expectations five years ahead, the rate sits at 2.4% as seen in Exhibit 3.  Longer-term bond yields tend to move in line with inflation expectations, whilst shorter-term yields will be more responsive to central bank rate decisions.

Exhibit 3: Forward 5y5y Inflation Expectations

Stocks vs. bonds

As bond yields get more attractive, this puts extra pressure onto equity markets as investors can get a safer yield in credit. One method to capture this differential – now sitting at 1.3% — is to look at equity and bond yields, which have fallen over the last year when looking at the S&P 500 earnings yield vs. U.S. 10-year yield (4.1% vs. 2.8%).  The average spread over the last 10 years has been 3.2%.

Whilst rate hikes from the Fed are inevitable in 2018, investors will be looking at the pace of the increase and just as importantly, the number of rate increases, which will create a more volatile environment.

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