Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, most investors should sit tight. The persistence of strong corporate and macroeconomic fundamentals in the face of the recent sell-off and spike in volatility strongly suggests that the duration of the market rout should be limited. Asset allocations for most investors have likely not moved materially and declines to date are not significant enough (in the context of the recent run-up) to justify reallocations on the basis of material changes in relative value.
Earnings growth has been strong globally, and both economic data and survey-based forward expectations have been improving. Yet markets have been selling off, culminating in a broad-based severe one-day decline on February 5. Relatively high valuations, particularly in US equities, increase vulnerability of markets, but the proximate catalyst is concern about rising rates, which were previously viewed as well anchored. The US ten-year Treasury broke through its prior high of 2.6% to touch 2.8% on February 2 on the back of a stronger than expected US employment report in which wage growth exceeded expectations.
Recent gyrations in the volatility market should not be viewed as indicative of underlying fundamentals and are more a byproduct of market technicals. Implied volatility (as measured by the VIX) has been unusually low and stable over the last couple of years. This has encouraged investment in inverse VIX exchange-traded products (ETPs) that generated strong returns in the prevailing low volatility environment with positive term structure. However, when the VIX rises, such products fall sharply and move to reduce their short positions by buying VIX futures. This may explain the market action late in the day on February 5, when the VIX had the largest one-day move in its history, increasing from 17 to 37, and moving above 50 in after-hours trading. Buying by VIX ETP issuers late in the day drove much of this surge. Levered long VIX ETPs were also buyers. With near-bankruptcy of the inverse ETPs, their exposure is now small and pressure from these products is immaterial.
Does this mean markets can breathe a sigh of relief? The precise bottom is always unclear, but from a longer-term perspective, the 7.8% peak-to-trough decline we have seen in the S&P 500 Index is close to the average 9% correction witnessed during the last 30 years. Moreover, the technical nature of the decline at a time of strong market fundamentals suggests that investors should not be concerned. Near term, there may be some continued selling pressure, as volatility levels have increased enough that volatility targeting strategies have moved outside of trading ranges, requiring some de-risking that is often executed over a period of days. Panic selling among retail investors would also increase if declines persist. Indeed, large S&P 500 exchange-traded funds have seen outflows in recent days. But as companies exit earnings-driven black-out periods and are again eligible to repurchase stock, this may provide a countervailing force.
Prospects for risky assets remain strong, provided fundamentals hold up. The increase in volatility alone is not a useful predictor of subsequent returns. Analysis by J.P. Morgan of subsequent returns when the VIX exceeds 35 indicates that absent recessionary conditions, returns over the next year are strong. Following seven of nine volatility spikes since 1990, subsequent one-year returns averaged 20%, ranging from 10% to 29%. Three of the nine periods were also associated with recessions, two of which saw negative 12-month subsequent returns.
As for bonds, we continue to urge caution in the more liquid, plain-vanilla segments of the market and suggest that investors limit duration. Yields remain low enough that they are vulnerable to decline should rates rise further as income provides a limited cushion to returns, and for credits, spreads remain tight. Prospects for central banks to tighten faster than priced in, inflation to rise faster than expected, and increasingly negative supply/demand fundamentals to pressure up yields are risks worth considering. As the US Federal Reserve shrinks its balance sheet, the European Central Bank cuts back on purchases, and the US Treasury increases issuance to fund fiscal spending, the G4 will see net new issuance this year after three consecutive years of shrinkage. Rates may have to rise to attract adequate capital. In this environment, investors should hold some sovereign bonds—as they are a useful diversifier—but should also own assets that could do well should rates rise at the same time risk assets sell off, an environment that has not been seen in decades. Less directional hedge funds, including trend-following strategies, could help hedge downside risk. Some illiquid diversifiers (e.g., life settlements, royalty funds) that rely less on economic growth for strong returns, also could generate positive returns in this environment.
Investors should remain diversified and maintain adequate liquidity while remaining neutral on risk assets. Even with the recent increase in bond yields, expected bond returns are low enough to suggest investors own the minimum amount they can tolerate, filling the gap with less directional hedge funds or including more systematic strategies like trend following, or for those that can take more illiquidity, illiquid diversifiers. If the market decline extends further without a deterioration in fundamentals, we will be looking for bargains.
Celia Dallas is Chief Investment Strategist at Cambridge Associates.
Originally published on February 6, 2018
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