The Bottom Line
- Concerns about rates and earnings have played a significant part in the two major downdrafts in U.S. stocks that rattled investors last year.
- But in 2019, stock volatility will likely be less driven by sentiment, than by the shrinking availability of liquidity to businesses and consumers.
- Higher rates and the Fed’s program of quantitative tightening are obvious reasons, since they both make borrowing less attractive. But the recent rise of the U.S. dollar, and widening of credit spreads1 also have an impact.
- Indeed, ClearBridge Investments annual outlook notes a pattern of delayed impact between the fall of liquidity and the rise of volatility in the S&P 500.
- Consider that liquidity can be measured by the term premium for bonds, i.e. the incremental yield the market demands for the additional time waiting to get repaid. One convenient measure of this is the flatness of the U.S. Treasury yield curve between 2 and 10 years.
- ClearBridge’s chart suggests that as the 2- to 10-year spread falls, especially as it goes negative, volatility follows in lagged fashion – signaling the prospect of greater volatility in roughly 18 to 30 months.
- As a result, it’s reasonable to expect that future gains in equity markets would be driven by earnings, political developments and valuations.
All data Source: Bloomberg and ClearBridge Investments, unless otherwise noted.
1A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
Spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.
Liquidity refers to the degree to which an asset or security can be bought or sold in the market without affecting the asset's price.
A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).
The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.