Good news is bad news: Deconstructing the market sell-off
Good news is bad news: Deconstructing the market sell-off
Making sense of why markets have changed course and where to find new opportunities
Stocks globally have experienced more than a week of tumultuous trading, with the US stock market officially in correction territory. And after being relatively sedate for years, the VIX Index has risen dramatically in recent days, indicating rising volatility. Stocks have moved so far so fast that investors have experienced financial whiplash and are trying to understand what caused markets to change course so abruptly. To put it simply, almost everything that should be a positive for stocks is now a negative for stocks. Consider:
• Strong wage growth. In the aftermath of the global financial crisis, the US jobs recovery had been very weak. But over the last several years, the employment situation has improved substantially — although wage growth has remained quite lackluster. Then the January 2018 employment situation report was released more than a week ago, indicating that US wage growth had risen significantly, reaching a level not seen since 2009. While one would assume that data indicating a major improvement in the quality of the jobs recovery would be greeted positively by markets, it was not. One reason is that higher wage growth is likely to cut into corporate profits, thereby lowering the earnings outlook. And, more importantly, higher wage growth raises the specter of higher inflation, which in turn suggests the US Federal Reserve (Fed) might have to act more aggressively in tightening. And so this data point was actually the trigger that began the sell-off.
• The passage of US tax reform legislation. The significant reduction in the corporate tax rate, which is expected to materially improve earnings for most companies, has been a positive driver for stocks — both before and immediately after the actual legislation was passed in December. However, markets are now beginning to realize that there may be a downside to tax reform legislation; it is projected to reduce revenues and therefore add significantly to the government’s deficit. The estimate from the Congressional Budget Office is that this tax legislation will add $1.5 trillion to the deficit in the next 10 years. That, in turn, means the expected issuance of more government debt — more supply being added to the market and, all else being equal, the potential for lower government bond prices and higher yields.
• The aversion of a US government shutdown. In the past, markets have reacted positively when government shutdowns have been averted. However, the bipartisan, two-year deal passed Feb. 9 to avoid a shutdown came with a big price tag: It is estimated that spending will increase by $300 billion. A perfect sign of the times was President Donald Trump’s tweet last week that this budget bill ends “the dangerous sequester,” a budgetary feature enacted in 2011 that implements across-the-board spending cuts in the event that the federal government can’t agree to a specific budget. In fact, it was the sequester that helped lower deficits in recent years. And so not only could revenues drop because of the tax reform legislation, but spending could increase because of this budget deal. This again could mean the issuance of more government debt — more supply being added to the market and, all else being equal, lower government bond prices and higher yields.
• The global economic expansion. Certainly, a key driver of stocks in 2017 was the improving global economic environment. However, at a certain point growth improves so much that central banks must begin tightening monetary policy. That point has arrived for the US and may soon arrive for other economies. Keep in mind that for years, markets have been basking in the sunshine of ultra-accommodative monetary policy, which has driven stock and bond prices higher. Central banks needed to employ such a strategy in order for economies to recover from the global financial crisis, especially given the absence of adequate fiscal stimulus. But now central banks, particularly the Fed, must worry about rising inflation. And so tightening is underway. This includes balance sheet normalization, which means more government debt could come to market and, all else being equal, lower government bond prices and higher yields.
• Protectionist policies. While many Americans are excited about the Trump administration’s “America First” trade policies, such an aggressive stance could result in retaliatory actions — and they may not be trade-related. I believe one of the biggest risks created by such protectionism is retaliation by major buyers of US debt: Countries such as Japan and China could reduce their purchases of US Treasuries — or may even sell off some of the Treasuries they currently own. This too could add to the supply of government debt in the market and, all else being equal, could lead to lower government bond prices and higher yields.
The implications for stocks
There are certainly other factors that have contributed to these market gyrations; however, the main driver is concerns about higher yields on government bonds. But why exactly could this be a negative for stocks? Higher interest rates have several implications:
• Rates play a role in valuations. Higher rates are expected to result in lower valuations for stocks, which would mean a re-rating for equities.
• Higher rates make fixed income instruments such as Treasuries more attractive to investors, which can cause flows to move from other asset classes to fixed income.
• Higher rates place pressure on borrowers, from governments to corporations to households. Rising rates typically mean lower spending, as more money must be allocated to the servicing of debt.
In summary, last year I wrote about how the “animal spirits” of investor psychology had taken over the market, driving stocks higher. I think animal spirits are still driving stocks — but this is a different animal. In 2017 and January 2018, the stock market’s spirit animal was the bull, a powerful force moving straight upward. However, I would argue that the stock market’s spirit animal is now the Chihuahua — a much smaller creature than the bull, but one that can make quite a bit of noise, jump up and down, run in circles and nip at investors’ heels.
With two Chihuahuas at home, I have firsthand experience seeing how these small but mighty dogs can scare other animals that are far larger — but their bark is usually worse than their bite. Don’t be scared by the Chihuahua market. Embrace it and take advantage of the opportunities such fluctuations offer for alpha creation.
Given the potential for disruption and higher volatility, I believe investors may consider:
• Alternatives, which may react differently than stocks and bonds to market moves.
• Strategies designed to focus on the low volatility factor within equities.
• Actively managed strategies, in which portfolio managers have the flexibility to find opportunities and seek to avoid risks that they see in stocks.
Given that valuations are stretched in the US, making US stocks particularly vulnerable, I believe investors may consider:
• Strategies that focus on the value factor within equities.
• A well-diversified multi-asset product.
• An increase in international exposure. While volatility has hit markets around the world, valuations are relatively lower in many markets outside the US.
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