Lessons from the stock market sell-off

by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada

Last week ended on a bad note. The yield on the 10-year Treasury moved up from 2.695% to 2.852% in just five days,¹ spiking on the release of the U.S. employment situation report for the month of January. Not only did yields globally then rise, but this brought on the biggest sell-off in U.S. stocks in nearly two years – which then spread to Europe and Asia, putting downward pressure on equities in those regions. As I write this, futures suggest an extension of the sell-off today.

The events of the last several days offered a taste of the risks I have written about in past blogs. One risk is that valuations had become so stretched for U.S. stocks that they were “priced for perfection” – making them more vulnerable to a pullback at any sign of negative news. Another risk is the potential for monetary policy disruption as the Federal Reserve (Fed) gradually tries to normalize. Markets have seemingly been ignoring the potential for more aggressive Fed tightening if signs of higher inflation appeared. One big sign – much higher wage growth – was apparent in last week’s U.S. jobs report, and now markets are scrambling to process the implications.

Keeping the sell-off in perspective

Newspaper headlines suggest that panic has set in. After all, the Dow Jones Industrial Average fell 4.1% last week, and the 10-year Treasury yield is at its highest level in nearly four years.² What’s more, Deutsche Bank has put out a warning that correlations among asset classes are very high, creating a major risk of “asset contagion” as one dislocation or pullback could cause a significant chain reaction.

Before investors start to worry, I think it’s important to keep things in perspective:

1. This sell-off should not come as a surprise, given that rising rates can alter valuations, causing a re-rating of stocks. Several market strategists have argued that if the yield on the 10-year Treasury were to rise to 2.75% or higher, it would cause a material re-rating of the stock market, sending stocks significantly lower. While some prognostications seemed overly dramatic when they came out – and still do – it illustrates the concept that higher rates may alter stock valuations.

2. We can’t assume rates will go up slowly and gradually. The reality is that the pace of rate increases may largely be dictated by economic data, particularly indicators of inflation. And it’s hard for rates to go up gradually if wage growth isn’t going up gradually. We may need to expect greater volatility in fixed income going forward.

3. A pullback in stocks is normal and could be healthy. Stocks have not experienced a significant pullback in several years; in fact, in the last two years, U.S. stocks, as represented by the S&P 500 Index, have not experienced a drop of 5% or more. That is not typical based on historical performance, and it suggests, based on a reversion to the mean argument, that the longer stocks go without any material correction, the deeper the next correction could be. Therefore, I believe we should welcome this pullback as a sign that the stock market is normalizing – and possibly creating buying opportunities along the way.

4. Higher volatility is healthy. U.S. markets have experienced artificially low levels of volatility for nearly a decade, since the start of the Fed’s quantitative easing. Such conditions are a sign of an abnormal market environment, impacted by very accommodative monetary policy, and have brought with them higher correlations. I’ve written about the potential for disruption to lead to higher volatility, which is what we’ve finally started to see this year. But investors should not fear higher volatility as it typically brings with it lower correlations and more opportunities to outperform benchmark indexes – particularly on the downside.

5. Financial conditions are still loosening, which should soften the impact of rising rates. Corporate bond spreads have fallen significantly, and high yield spreads have moved slightly lower. According to the Fed’s most recent Senior Loan Officer Survey, banks are reducing lending standards on new business loans. The Chicago Fed’s National Financial Conditions Index suggests that current financial conditions are looser than we have seen in years. And monetary policy outside the U.S. remains very accommodative. These factors should provide an environment that is still supportive of growth in the face of rising rates.

6. The bias for global stocks remains upward. The global economic environment is accelerating, with the International Monetary Fund recently upgrading its expectations for global growth. U.S. growth also appears to be improving (after all, the jobs report that triggered the jitters was a positive one, showing job gains above expectations). The Atlanta Fed GDP Now Model recently forecasted 5.4% GDP growth in the first quarter of 2018; while this seems too high, in my view, it certainly suggests an improving growth environment. Earnings season has been positive as well, and earnings are expected to improve this year.

Don’t panic – prepare

In summary, I believe this more volatile and tumultuous market environment will continue, but stocks may not just experience downward volatility – I expect upward volatility as well. In addition, we should expect higher volatility not just in equities, but also in the fixed income market. Finally, Deutsche Bank’s warning about the possibility of “asset contagion” should not be ignored. Global markets are tightly interconnected, and it would not be a surprise to see sell-offs in some assets or regions infect others.

We also must recognize that the dramatic reaction to signs of inflation in the U.S. could happen again this year – that’s part of being in a rising rate environment. It could also happen elsewhere. Consider that the European Central Bank (ECB) has started to slowly normalize monetary policy through tapering. The assumption by markets has been that ECB normalization will be very gradual because inflation is so low – similar to the assumption that has been made about the Fed. While it seems likely that European inflation will remain low and that normalization will be very gradual, that situation could change – just as it appears to be changing in the U.S.

And so we need to be aware of the risks – but we shouldn’t let those risks scare us away from markets. Keep in mind these key long-term investing tenets:

• Maintain broad diversification. For many investors, this could include not only stocks and bonds, but also an allocation to alternatives

• Don’t be scared and don’t be impulsive. Be disciplined no matter what the market environment, and keep saving and investing according to your long-term plan

Subscribe to the Invesco Canada blog and get Kristina Hooper’s market reviews in your inbox.

This post was originally published at Invesco Canada Blog

Copyright © Invesco Canada Blog