Volatility returns to the Equity Markets

16 Feb

Volatility returns to the Equity Markets

In the last two weeks volatility has made a return to the stock markets after a lengthy absence. On Monday the 5th Feb the Dow Jones Index fell by 1755 points or 4.6%. There was no apparent reason that caused the downturn but worries about the new head of the federal reserve in the US and rising interest rates were partially blamed. Good jobs numbers should be seen as a positive ,  however the markets will fret that this will lead to higher wages are a result of a too tight labour market and that businesses are having to pay up to attract more staff. The key is whether any of this feeds through to higher inflation, something that central banks are of course charged with containing. The fact that markets have had a strong run in recent months really just increased the chances of a minor correction.

It is worth putting this into context however. The previous two interest rate tightening cycles in the US were in 1994 and 2004. During these periods the US economy was performing well, but the central bank, the Federal Reserve feared that inflation might return. We then saw a period of fairly rapid interest rate rises which hit bond markets quite hard. Equity markets were not immune from this, although the falls in the S&P 500 were limited to less than 10% on both occasions. Thereafter, stocks continued to perform well, reflecting the continued growth in the economy and in company profits. This is probably the type of adjustment markets are experiencing at the moment.

Major setbacks in markets, so-called bear markets, are more normally associated with economic recessions. Given the current improvement seen in the global economy, these conditions do not seem to be upon us now or indeed anytime soon.

There are essentially three principle reasons causing the current market volatility:

1) Inflation fears: Recent US wage data released was higher than expected which caused US bond prices to fall and yields to rise. However, this is offset by the reduction in inflation fears.

2) Technical trading: Traders who chart technical levels in global stock markets will buy or sell when markets hit certain levels, regardless of fundamentals. The US stock market hit those levels and triggered sales. This has been exacerbated by a spike in the volatility index (VIX) causing further technical sales.

3) Finally, stock markets have been on a strong upward run for some time. In fact, they were only 4 days short of the longest period without a 5% correction. It is not unusual for markets to correct from time to time, and such corrections are typically less than 15% in magnitude and short term in nature. Volatility in stock markets is perfectly normal but has been very low for some time. In other words, this pullback is not unexpected.

The major problem with this type of short term volatility is that it can cause uncertainty and tempt investors to ‘do something’. However, in recent years, the best solution has proven to be to remain well diversified and stay invested. That advice is particularly relevant now.

Outlook from Irish Life Investment Managers:

Despite the recent falls in the stock market, our investment managers are positive on the outlook for equities in 2018, with high-single to low double-digit gains expected for the year.

The positive economic and earnings backdrop continues to be supportive, and provides room for further upside in equities. While global equity valuations are no longer cheap in absolute terms, they are not stretched relative to levels seen previously in the main crisis periods. Also the positive fundamental and earnings backdrop provides scope for equities to rise in line with earnings, while maintaining current valuation levels.

Equities are also very attractive on a relative valuation basis, compared with bonds and cash. This is largely due to the low yields currently available on these assets. While some further upward pressure on bond yields is possible in 2018, we do not believe that yields will rise to the levels that place undue pressure on equities.

While various risks continue to overhang markets and could lead to further short-term drawdowns in equities, we believe the positive fundamental backdrop will result in equities ending 2018 as outlined above with high-single to low double-digit gains for the year as a whole.