Jurrien Timmer: The Conversation We’ll Be Having for Years to Come

Jurrien Timmer: The Conversation We’ll Be Having for Years to Come




by Jurrien Timmer, Director of Global Macro, Fidelity Investments

SEPTEMBER 2017

The Conversation We’ll Be Having for Years to Come

It’s time to consider what a return to conventional monetary policy could mean for asset valuations.

Key Takeaways

  • Global stock markets continue to be resilient despite recent geopolitical pressures.
  • Strong earnings growth and generally easy monetary policy around the world have helped prop up the markets.
  • The big question facing investors for the next several years is how markets will react when central banks start to exit from this era of ex.traordinary monetary accommodation.
  • The solid global economy, robust earnings, and low inflation could help central banks normalize with just a modest downward adjustment to the unusually favorable risk-return landscape.
  • The low-vol march to Dow 22K and beyond

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Volatility briefly returned to financial markets in mid-August, temporarily reversing the seemingly impossible disparity between low market volatility and high geopolitical and policy uncertainty. The VIX1 volatility index shot up to 17 (before settling back at 12), but that’s still well below where it could go if something truly bad happened. For example, the VIX flirted with 90 during the 2008 financial crisis.

I continue to believe that these are the “known” risks for the remainder of 2017:  China has a post-reflation hard landing (not likely for 2017 but maybe in 2018?)  The Fed tightens much more than the market has priced in (not likely for 2017, maybe in 2018?)  A geopolitical shock (always possible, but impossible to predict) Barring an extreme geopolitical crisis, the known risks should be manageable, and a well-balanced, diversified portfolio likely remains the best solution for most investors. That said, however, the risk-reward trade-off for stocks during the past 18 months has rarely been more favorable. Since the first quarter of 2016, the S&P 500® Index is up 32%, versus a standard deviation2 of only seven. That’s three times the market’s average annual return against half its historical risk. This is unlikely to be sustainable over the long term.

That doesn’t mean a correction or a bear market is imminent. Historically, periods of low volatility can persist for some time. Case in point: Exhibit 1 shows that the current volatility of the S&P 500 is at its second-lowest level since 1970, against a year-over-year return that’s at the 56th percentile (meaning the market has had a lower return 56% of the time and a higher return 44% of the time). But as the chart also shows, in early 1996 volatility was at a post-1970 low while its return was near a post.1970 high (96th percentile). A year later, volatility shot up dramatically (36th percentile), but the S&P 500’s return remained high at the 82nd percentile. The message is that these regimes can persist for some time, and even when they end it doesn’t necessarily mean the market is going to plunge.

Meanwhile, the Dow Jones Industrial Average has eclipsed 22,000, another milestone for one of the biggest bull markets in history. As records continue to fall, it’s worth remembering that over the long run stock prices follow earnings, and earnings are on track to grow double-digits this year. It’s no wonder the market is reaching new heights. Easy financial conditions,3 a weaker U.S. dollar, and a synchronized global economic expansion (led by China) are an ideal trifecta for keeping this bull market going.

Source: Haver Analytics, MSCI, Fidelity Investments, as of Aug. 13, 2017. All indices are unmanaged. You cannot invest directly in an index. Past performance is no guarantee of future results.

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