- The recent equity correction was quicker and less convincing than similar selloffs, suggesting the bull market could endure more volatility before resuming its run.
- Higher interest rates should not be an impediment to stocks or business and consumer spending.
- Inflation poses less of a risk to the markets than the escalating threat of a trade war.
- Our Recession Risk Dashboard suggests the U.S. economy should remain on sound footing in the near term.
Pullback Likely to Keep Volatility Elevated
Our view entering 2018 was for higher volatility across equities, fixed income and interest rates coupled with a heightened possibility of a pullback. This perspective was based on the knowledge that the market was embarking on its longest stretch without a 5% correction in 90 years. As many investors know, timing for such a drawdown can be difficult to predict. Although there wasn’t an obvious catalyst at the time, complacency was running rampant, materially raising the possibility of a reversal. The passage of U.S. tax reform gave rise to the final euphoric push higher before the selloff.
We believe the correction that occurred over the last two months will ultimately be a buying opportunity for equities. Sixteen draw-downs of 10%+ have occurred since 1976, five of which transpired around recessions. Of the 11 non-recessionary corrections, only the 1987 crash turned into a full-fledged bear market (20%+ loss). With the ClearBridge Recession Risk Dashboard signaling little probability of a recession at present (Exhibit 1), we believe the current pullback has largely run its course and the bull market will continue to run in 2018.
Exhibit 1: ClearBridge Recession Risk Dashboard
It’s important to view bull market corrections through a three-dimensional lens of price, time and sentiment. Pullbacks need to see progress on all three of these fronts for the market to move forward. The market has lost over 10% of its value from peak to trough. Judging from history, this satisfies the price component of a correction. However, work still needs to be done with regard to both time and sentiment.
Historically, the non-recessionary pullbacks of 10%+ have played out over 70 trading days, or approximately three months. The current pullback started in late January, suggesting the potential for more choppiness in the near term.
The final ingredient for a correction to end is a change of sentiment. One way to gauge the level of investor sentiment is through surveys such as the Investors Intelligence Bull-Bear Ratio. This ratio hit record levels of optimism during the weeks leading up to the downturn (Exhibit 2). At its January peak, there were over 5.3 bulls for every bear. Typically, a reading over 3 signifies a high level of bullishness and complacency. With the ratio currently at 3.3, there is still some complacency, although this is much healthier than the extremes seen in January.
Exhibit 2: More Bulls Than Bears
Given these dynamics, we would not be surprised to see the market remain in a trading pattern to start the second quarter. Bottoming is a process that usually takes longer than market participants expect. In our view, the strengthening global economy and earnings backdrop will eventually win out. None of the factors responsible for this selloff change the longer-term fundamental picture. Before we dive into that backdrop, let's examine some of the catalysts behind the selloff in more depth.
Many market observers point to the unwinding of the short volatility trade as a cause of the recent downturn. 2017 was one of the lowest volatility years on record, with the CBOE Volatility Index (VIX), a measure of market volatility, averaging just 11.0 compared to its mean of 19.4 since it was created in 1990. With volatility low, more than $3 billion in assets flowed into short volatility products last year. This trade was very profitable until everyone tried to exit at the same time, not dissimilar to someone yelling fire in a crowded movie theater. Furthermore, many of the more popular short volatility products were leveraged, magnifying the risks. Initially, the VIX more than doubled and spiked to its highest level since 2011, while the market lost only 4.1%. This is a 25:1 ratio between the VIX and the S&P 500, which is well above the 8:1 long-term relationship. The VIX and stocks have begun to re-establish a relationship closer to the long-term average more recently, suggesting this dislocation has made its way through the system. Put differently, we believe this shows that much of the technical selling has run its course and the equity selloff is not a symptom of something much more systematic.
Stocks Can Absorb Higher Level of Interest Rates
Another oft-cited catalyst for the market pullback is the rapid rise in interest rates. Since mid-September the yield on 10-year Treasurys has climbed from 2.04% to 2.81%. Last quarter, we highlighted our expectations for higher rates; however, the speed of this rise has been faster than we anticipated. Should investors fear higher rates? History would suggest not. Higher rates are generally accompanied by a positive stock market because of the higher economic growth that accompanies them. In fact, there have been six extended periods of rising rates since the 1990s, with an average rise of 182 basis points (bps). During these periods, the market rose at a 16.8% annualized rate (Exhibit 3).
Exhibit 3: Markets Climb as Rates Rise
|Rate Cycle||10-year Bond Yield Rise (Bps)||S&P 500 Return|
|Oct 1993-Nov 1994||252||-1.0%|
|Jan 1996-March 1997||133||18.0%|
|Oct 1998-Jan 2000||225||26.7%|
|June 2003-June 2007||165||11.5%|
|Jan 2009-March 2010||161||23.0%|
|Aug 2012-Dec 2013||156||23.0%|
The magnitude of the move in interest rates is also important, with the market gaining an average of 15.6% annualized when rates have risen 50–100 bps, which is where we are currently (Exhibit 4). When rates have risen more than 100 bps, stocks still delivered an average return of 12.6%.
Exhibit 4: Magnitude of Rate Rise Can Help Returns
The futures market, which can help gauge investor expectations for specific asset classes, suggests there is a good possibility that rates may continue to rise. Currently, there are near-record levels of short positioning for 10-year Treasurys, a trade which profits when interest rates rise. A good rule of thumb is that if everyone is on one side of a trade, the opposite scenario will play out, a phenomenon better known as the pain trade. This may keep the 10-year Treasury range-bound in the second quarter, with rates resuming their rise later in the year.
Importantly, we believe rising rates should be well absorbed by both businesses and the broader economy. First, higher rates reflect improving economic growth expectations, which is good for consumers and their employers. Second, the impact of higher rates will be dampened in the near term due to the higher share of fixed-rate debt outstanding, making borrowers less sensitive to rising rates. From a corporate perspective, many businesses have taken advantage of low rates to issue debt in recent years. However, this can potentially be an issue when this debt is refinanced at higher market rates in the future, requiring a greater amount of cash flow to be diverted toward interest payments. Further, if lending conditions tighten, companies may face an environment where ready lenders are not available.
The good news is that neither of these conditions are an issue at present. The maturity wall for corporate borrowers has been pushed out to at least 2020, meaning most borrowers won’t face higher borrowing costs or the risk of needing to roll over debt in an illiquid market for a few years. Additionally, both consumers and businesses have near record low debt-servicing ratios, which means they have a solid cushion against rising rates.
Another potential catalyst behind the market’s selloff is inflation. Over the past two years, the market’s focus has shifted from deflation to reflation and now to inflation. Just how much inflation will occur is the wild card for markets at present, due to the Fed’s dual mandate of full employment and stable prices. In a typical economic cycle, inflationary pressures will pick up steam as the cycle matures, leading the Fed to quickly raise rates to head it off. It’s an imperfect science since monetary policy often acts with a lag, frequently one to two years. As a result, several expansions have been brought to a premature end due to overtightening.
Inflation Pressures Likely to Moderate
January’s initial wage growth print of 2.9%, coupled with Fed Chair Powell’s optimism on the economy, spooked investors into thinking that the Fed was behind the curve and a faster pace of tightening would be forthcoming. However, February’s employment print and the most recent FOMC meetings should help alleviate these concerns. Wage growth came in at a steadier 2.6% (and January was revised down to 2.8%), while 313,000 jobs were created in February. Perhaps more importantly, the labor force increased by 806,000 during the month, the largest gain in 15 years. With elevated business and consumer confidence, discouraged workers who previously exited the workforce are now finding opportunities.
The U.S. labor force participation rate has fallen from 67% in 2007 to 63% currently. While a good portion of this drop can be attributed to demographic forces (Baby Boomers retiring/an aging population), there are still millions of workers on the sidelines. If more workers are available, the headline unemployment number overstates the tightness of the labor market. If workers continue to enter the labor force, wage inflation may rise gradually but remain below levels that would cause the Fed to tighten monetary policy more aggressively and spook investors.
In fact, we interpreted March’s FOMC minutes to be dovish, with the projected Personal Consumption Expenditure (PCE) inflation rate above its 2% target in both 2019 and 2020. This is important as it suggests that the Fed is willing to overshoot its target in the medium term to have sustained 2% inflation. There have been several occasions during the current recovery where core PCE (which does not include food and energy) hit 2% only to fall quickly back below target. We believe the Fed recognizes this phenomenon and won’t overreact to a rise in inflation modestly above 2%. While several indicators suggest rising inflation, the backdrop appears quite different from the 1970s when inflation ran away. Demographics, technology and high debt levels should act as secular disinflationary forces that will keep inflation in check.
Finally, the prospect of a trade war has been a drag on the markets so far in 2018. We examined this issue in a recent blog post. We believe more U.S. companies would be hurt by a trade war than helped, with negative impacts on margins and profits. However, the Chinese demonstrated a willingness to negotiate during Trump’s visit in November and we believe a compromise will ultimately be reached. Importantly, we view volatility emanating from these issues as a buying opportunity for longer-term investors.
None of the catalysts behind the recent pullback laid out above have changed the larger backdrop for the market. Fundamentals remain solid, with the U.S. economy on sound footing according to the ClearBridge dashboard. At present, none of the 12 variables are at levels consistent with a recession, indicating the chances of a recession this year remain below 10%. Corporate earnings growth remains robust (mid-to-upper teens growth in 2018), monetary policy is still quite supportive, the cyclical economy is not overheating, global growth is healthy, consumer and business confidence remain elevated and there are no obvious bubbles lurking on the horizon. Valuations are far from stretched after this pullback and tax reform. The forward P/E for the market is 16.1, well below the 30-year average of 19.4. This healthy fundamental backdrop should prove advantageous for equities.