Ill-fated volatility trades exacerbated a global equity selloff partly triggered by rising rates, but we see reason to look through near-term uncertainty. While last week’s rout spread across equity factors, geographies and styles, contagion to other asset classes was mostly limited. We believe investors should take the long view amid upbeat fundamentals.
Last Monday’s spike in the U.S. equity volatility gauge was literally off the charts. See the orange dot in the upper-left corner of our chart of the week. The chart shows just how outsized the VIX surge was relative to the move in the S&P 500. The disconnect between the two was more dramatic than anything seen during the depths of the financial crisis or in the aftermath of the Brexit referendum. The volatility spike comes at a time when market worries over increasing real bond yields (rather than over rising inflation) have taken center stage. The reason: Market perceptions are adjusting to higher U.S. growth and deficits. The S&P 500 ended the week down 9% from its record high touched on January 26, bringing it back to where it was in late November 2017.
Digesting rising rates
The extreme volatility initially was limited to equities, as discussed in The stock swoon in context, but by the week’s end had resulted in some credit spread widening. Rising rates and the end of the one-way volatility-selling trade suggest markets are unlikely to return to the unusually calm conditions seen last year. But, for now, we do not expect the episode to spur a regime shift. An about-face would require a deterioration in the economy and an accompanying rise in macro volatility. We see few signs of either. Our BlackRock Growth GPS for G7 economies is at its highest levels in three years. Consensus forecasts are catching up to our GPS as the expected boost from U.S. fiscal stimulus gets baked into forecasts. We expect the rise in inflation to be modest and the Federal Reserve to tighten gradually, and see further yield rises capped by investor thirst for income and high global savings looking for a home.
A risk to our sanguine view is the potential for a swifter rise in rates as markets are waking up to stronger growth and rising budget deficits. This helped spark the equity retreat and offered a stark reminder that the pace of rate increases matters. One trigger for quickening that pace is the U.S. government’s ambitious spending plan—a sea change from years of fiscal consolidation. We see this resulting in a jump in Treasury bond issuance that markets have yet to fully acknowledge. This could put more upward pressure on yields.
Higher real yields change the relative value proposition of stocks and bonds, raising the bar for equities and other risk assets as investors re-assess risk/reward. This highlights one of our key 2018 themes: We expect investors still to be compensated for taking risk—but receive lower rewards. We believe the benign economic backdrop and strong earnings momentum provide a solid foundation for putting money to work in equities. We find that equity pull-backs are short and recoveries quick in low macro volatility regimes. Read more market insights in our Weekly commentary.
In the latest episode of The Bid podcast, Chief Fixed Income Strategist Jeff Rosenberg talks about the risks we foresee in the year ahead and the role of fixed income in a market environment that’s heating up.