Liz Ann Sonders: Volatility ... It's back!

by Liz Ann Sonders, Brad Sorensen, Jeffrey Kleintop, Charles Schwab and Company

Key Points

  • The long-awaited return of volatility has arrived, unnerving investors. But economic and earnings fundamentals remain strong and this is part of the process of returning to a more “normal” market environment.
  • The U.S. economy is showing improving growth, earnings season has been strong, and earnings expectations for 2018 have surged; but expectations are elevated and the rate of improvement in both is likely to slow.
  • Global stocks were not spared but the fundamental picture internationally also looks solid.

It’s Back

In what has been a long time in coming, but took some investors by surprise with both the timing and the violence of the move, volatility returned to the stock market in the last couple of weeks. To investors who became accustomed to the low-drama market environment, it may have come as quite a jolt. After all, we just saw the first back-to-back declines in the S&P 500 in 310 trading days! The spike in volatility led to a massive unwinding of “short vol” (short volatility) positions as well as forced selling of other securities or assets to cover their short positions. The short-vol trade had taken over from the “long Bitcoin” trade as of the end of January, according to a recent Bank of America Merrill Lynch fund managers’ survey and its unwinding led to a technical kicker to a selloff which began on fears of higher interest rates.

Volatility spike contributed to more volatility

VIX Index

Something or nothing?

The bigger concern is whether the recent selloff in stocks is a harbinger of more serious and long-lasting damage to come. Although we don’t yet know the extent of the carnage within and associated with the short-vol space, we do believe the recent pullback is healthy for the continuation of the bull market. Recent action has allowed extremely stretched sentiment conditions to correct somewhat. According to the Ned Davis Research (NDR) Crowd Sentiment Poll, investor optimism has come off the record highs seen a couple of weeks ago. We believe some of the recent action is part of a process of resetting investor expectations to more reasonable levels. Business optimism has come in a bit as well as we’ve seen some downticks in manufacturing surveys, which indicate continued strength but at a slightly more modest pace.

Manufacturing still strong, but a modest downtick

ISM Manufacturing Index
Empire Manufacturing Index
Chicago Purchasing Managers Index
Philly Fed Manufacturing Index

A precipitating factor which underpinned the initiation of this corrective phase was a spike in the 10-year yield to above 2.8% and rising expectations for a faster pace of rate hikes by the Federal Reserve. The concern boiled over following the release of the recent labor report that showed average hourly earnings rose 2.9% year-over-year, the highest rate of growth since June 2009, leading to the thought that the Fed may have to be more aggressive. Although we do think the landscape for wage gains to translate to higher inflation, the severity of the market move may have exaggerated the impact of the wage increase; and several Fed speakers have recently expressed the belief that higher wages won’t necessarily lead to significantly higher inflation (James Bullard-February 6 and Robert Kaplan-February 7-both reported by CNBC).

That said there are two notable developments over the past few months which augur for a higher inflation trajectory than what we’ve seen so far in this cycle. One, the “output gap” (the spread between actual and potential economic growth) has moved from negative to positive; meaning the economy is now operating above potential. Second, nominal gross domestic product growth (GDP) is now higher than the unemployment rate. For both, it’s the first time we’ve seen this since before the financial crisis. Both shifts suggest at least a mildly higher wage and/or inflation outlook.

Rates higher but still historically low

10-year Treasury yield

Past performance is no guarantee of future performance.

Economic growth, as well as corporate earnings, have kicked into higher gear, which is likely to persist in 2018. Capital spending is expected to be an added kicker—helped by the change in the tax code to allow for immediate expensing as well as the likely repatriation of cash from overseas. The average age of U.S. assets is at record highs according to BCA Research and this environment allows companies the opportunity to make further productivity-enhancing investments.

Another story has begun to shift, and that is around financial conditions. In an unprecedented stretch, the Fed has been hiking rates since December 2015, while more recently also beginning to shrink its gargantuan balance sheet. Although both are considered tightening measures, until recently, financial conditions hit were quite loose. But as most of those measures include stock market activity, they have begun to tighten.

Financial conditions beginning to tighten

Bloomberg Financial Conditions Index

Source: FactSet, Bloomberg. As of Feb. 7, 2018.
Figures above zero indicate improving conditions.

A positive corporate environment is helping to bolster the American consumer. Consumer confidence as measured by the Conference Board actually rose further from an already high 123.1 to 125.4. The job market remains strong, with jobless claims remaining near historic lows; and the recent Department of Labor report showed 200,000 jobs were added in January, while the unemployment rate stayed at an historically low 4.1%. This strength and confidence also appears to be filtering through to the housing market as the homeownership rate is finally moving higher. It appears that many who were burned by the last housing crisis, and Millennials, are also increasingly embracing homeownership.

Homeownership rising

Homeownership rate

But while traditional fundamentals remain relatively sound, the expectations bar has also likely been set a bit high, setting up the likelihood of more market volatility—both in the stock and bond markets. A higher bar is also applicable to corporate earnings: earnings estimates for the full year 2018 were boosted as analysts started to incorporate tax-related savings—moving from an estimated 11.2% growth rate for 2018 before the Tax Cut and Jobs Act was passed to 18.5% rate currently, based on Thomson Reuters data. While strong earnings growth—and the recent pullback—helped ease the high valuation problem, the enthusiasm around the tax-related boost to earnings may have gotten ahead of itself. This could be seen in individual stocks selling off with even minor disappointment during their earnings reports.

Risk to the bull

As mentioned, we don’t believe the bull market’s continuation is in great danger at this point but we are watching the aforementioned market structure dislocations as well as the more fundamentally-oriented inflation picture. We’ve also seen commodity prices rise, employment costs move up, and various surveys show indications of higher inflation; such as the last ISM Manufacturing report that showed the prices paid component rose from an already high 66.3 to a robust 72.7.

CRB BLS Spot Commodity Index
Employment Cost Index

Moving away from the deflationary threat is a positive, but we don’t want too much of a good thing. The Fed stayed pat at the most recent meeting, which was Chairwoman Janet Yellen’s last, but March appears likely to bring another hike. We’ll be watching the statement and new Chairman Jerome Powell to see if the Federal Open Market Committee (FOMC) is becoming more concerned about the recent uptick in prices that we’ve seen. What we have seen is yet another new Fed chair ushered in with a spike in market volatility—which was the case with Alan Greenspan, Ben Bernanke, Janet Yellen, and now Jerome Powell.

The global market pullback

The pullback in stocks has been felt in stock markets around the world and returned global stock markets to where they were at the end of last year. But in our view it has had little spillover to related markets like currencies, commodities or credit to this point.

It isn’t unusual to see pullbacks. The peak-to-trough drawdown in global stocks so far this year, at about 8%, is only about half of the average annual pullback of the past 37 years. That could mean there is more to come, either for the current pullback or additional pullbacks over the course of the year. Global stocks have fallen from peak-to-trough by more than 10% in two-thirds of the years since 1979; yet most of those times still posted a gain for the year, as you can see in the chart below.

Declines are common and usually don’t mean losses for the year

MSCI World Index annual returns

Past performance is no guarantee of future results.
Source: Charles Schwab, Factset data as of 2/7/2018.

The pullback in stocks that began last week is different from every other pullback that preceded it over the past eight years, since it was likely triggered by fears of too much growth and the return of inflation, not too little growth and deflation. An overheating global economy could mean a more rapid shift by central banks to rein in stimulus, often a precursor to recession. Yet, we still believe a recession is not on the near-term horizon. Financial conditions have shown few signs of significant deterioration as was the case during the bear markets of 2008 and 2011, as you can see in the chart below; suggesting a recession and bear market may still be a year or more away.

Financial conditions show few signs of deteriorating as they did in 2008 and 2011

Financial conditions indexes

Past performance is no guarantee of future results.
Source: Charles Schwab, Bloomberg data as of 2/7/2018.
Figures above zero indicate improving conditions.

Stocks may reconnect with the rising trend in earnings, as they did two years ago, which you can see in the chart below. Even during the current pullback, more earnings estimates were raised by analysts than were cut.

Stock prices have disconnected with earnings as they did two years ago

MSCI World EPS estimates

Past performance is no guarantee of future results.
Source: Charles Schwab, Factset data as of 2/7/2018.

Growth remains solid and the pullbacks this year are likely to be temporary. But, increased volatility and the advanced stage of the business cycle mean that staying globally diversified and frequently rebalancing back to target allocations are important.

So what?

Volatility returned with a vengeance but investors should stay focused on the longer-term, especially given the technical-driven nature of the dramatic surge in volatility. The “machines” behind some of the market’s gyrations have time horizons measured in nanoseconds—investors should not. Ultimately we believe fundamentals should reconnect with prices. Earnings and the economy—both domestically and abroad—remain strong and Fed officials have thus far remained sanguine with regard to inflation. But this round of volatility should also remind investors that markets do not go up forever, corrections are normal and healthy, and discipline (diversification and rebalancing in particular) is key.


Copyright © Charles Schwab and Company

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