The V in Volatility

February 14, 2019

3 minute read

by Joseph V. Amato, President and Chief Investment Officer – Equities, Neuberger Berman

The equity rally is likely just the start of a volatile adjustment to a new fundamental reality.

“Investors who sit out now could miss a chunk of this year’s returns.”

Those were the last words that I wrote in one of our CIO Weekly Perspectives in January. Since then, the S&P 500 Index has been consolidating its New Year performance. Those brave enough to buy as the markets closed on Christmas Eve now sit on a return of around 15%, thanks to gains on three out of every four trading sessions. The Europe STOXX 600 and MSCI Emerging Markets Indices are both up by around 10%.

I didn’t expect our words to be affirmed so quickly. And after a couple of days of jitters at the end of last week, it’s worth remembering that the statement was not just about the size of the New Year rally, but also about its limits.

Global Economy Continues to Slow

Regular readers will know that we have long anticipated that the Federal Reserve would err on the side of patience with rate hikes and guide the U.S. economy into a soft landing. The past two weeks have seen it adopt that stance explicitly and offer commentary that is, if anything, even more dovish, even as the U.S. generates an average of 220,000 jobs a month paying wages that grow by 3.2% a year.

While the world’s biggest economy exhibits few signs of imminent recession, however, several indicators from the rest of the world continue to disappoint.

China’s Caixin Purchasing Managers’ Indices, for both manufacturing and services, declined further this month.

In Europe, Spain is the rare highlight, as Germany, France and Italy pushed the euro zone composite PMI to its lowest level in more than five years last week. Italy is now in technical recession and Germany, still struggling with a slump in auto sales, only missed it by one-tenth of a percentage point. Last week, the widely followed euro area Sentix survey of institutional investor confidence dropped to its lowest level in four years. And across the English Channel, as the Brexit deadline nears, the U.K.’s plummeting services PMI added to poor manufacturing and construction data to paint a picture of an economy stalling on sheer uncertainty.

Halfway through fourth-quarter earnings reports, we are also starting to see some fatigue at the corporate level.

As Deutsche Bank pointed out in a U.S. Equity Strategy research note on January 31, despite substantial downward revisions, the proportion of S&P 500 companies beating analysts’ earnings estimates was the lowest for seven years. Earnings-per-share growth expectations for 2019 are now coming in at around 4%, on average, compared with 10% last summer, according to the RBC Capital Markets’ “Halftime Report” that came out on February 5. While the tax impact has turned from a substantial tailwind to a small headwind, these are still sluggish numbers.

Inflection Points Bring Extremes in Both Directions

With that as the background, the New Year rally looks even more remarkable.

When every piece of news was perceived as bad news at the back end of 2018, stocks seemed to be disproportionately punished for marginal earnings-season disappointments. Today, investors seem only to hear the good news, bidding up stocks that are protecting margins or telling the least-negative stories.

Notwithstanding our relatively benign soft-landing scenario, investors will likely need time to adjust to the idea that the global economy is slowing down—not into recession, but meaningfully, and probably for the duration of the current cycle. When markets stand at inflection points such as these, expect extremes of sentiment and momentum on the upside as well as the downside. After December’s sell-off, January’s rally has given us the “V” in volatility, but volatile times rarely stop on a dime.

We remain constructive on risk assets given our soft-landing scenario and reasonable valuations. But volatility will likely continue to haunt us as the economy and markets adjust to a more modest growth outlook, and those who panicked at year-end have probably missed a chunk of 2019’s equity returns.

Like 2016, this year could prove a good reminder of why, as the saying goes, time in the market often contributes more to long-term returns than timing the market.