Healthy Correction: The Return of Volatility

Healthy Correction: The Return of Volatility

Ultimately, we believe this market correction is healthy. While clearly painful in the short-term, it is building a base from which the global risk markets can not only recover but do well over the coming year or two.

Is this most recent market move a healthy correction, or something more serious?

Here is how we’re thinking: don’t just look at the U.S. economy – look at the global economy. The world economy itself is doing very well right now. Markets may be anticipating an uptick in price inflation from higher wages and higher oil prices but there could be a lag effect for this cycle. Central banks should not have to adopt a more aggressive response.

In our view, it is certainly a case where markets have just grown too fast, too quickly—particularly equity markets. We think the current situation is one in which financial markets – for a while at least – are going to be a lot more volatile than what the underlying economy suggests. We expect to see more two-way price action over the coming months.

Bottom line: We do not think this is a trend-changing market sell-off; we are just working some bullish sentiment excesses out of the market. Our base case of sustained broad-based global growth should remain intact.

What are the reasons behind the sell-off? 

There was too much complacency in the global financial markets. Sentiment was leaning one way in terms of bullishness, with too much capital dedicated to low-volatility strategies. And, as we know, volatility itself is mean-reverting. When you sell volatility, you are basically picking up nickels in front of a bulldozer. It works until it doesn’t, and it always ends in a pain trade. We saw extremely low levels of volatility in 2017. Now, we are starting to see volatility revert to the mean, which is an upward move. And with a return to volatility will come a market with downs as well as ups.  

Another factor that spooked the markets is the potential for the Federal Reserve to become more aggressive with its rate tightening cycle.  Stronger economic data has unsettled equities because of expectations of what the Fed might do as a result. And, bonds have been moving in line with equities in recent weeks as opposed to how that relationship normally works.

Ultimately, again, we are not looking for this turbulence to become a trend-changing event. Instead, it should be an opportunity to readjust portfolios toward “risk” at more appropriately priced entry points.

Once the sell-off bottoms out, could we see attractive niches opening up in various fixed-income classes?

We have been and will continue to be constructive regarding higher-quality, local-currency emerging market sovereign bonds. I would also suggest the same for emerging market equities. We believe the recovery in emerging markets and their economies will last for years. We continue to see improving economic fundamentals around the globe, particularly in the developed world. And now the emerging world is catching up and should continue to expand from an economic growth standpoint. We also remain positive on China during 2018.

Do you expect to see a reversal of the yield curve flattening we saw in the last few weeks of 2017?

There has been some concern from markets that the recent flattening of the yield curve suggests growth might slow down. But in our view, the flattening pattern is reflective of tame inflation. If the yield curve steepens, that might be a sign that inflation expectations are becoming a little less anchored and that the Fed might be behind the curve and will need to sound more hawkish.

What is your opinion regarding duration?

We like longer duration in emerging markets. There are improving economic fundamentals in the sector, meaning less credit risk. Additionally, their inflation dynamics remain constructive in that inflation expectations are still too high and should improve as emerging market currencies have stabilized.

We are not constructive on the U.S., the core Eurozone, and the U.K. bond markets. Right now, European bond markets look more expensive than others. But we really believe that the European economy is on solid footing—and for that matter the global economy as well. We expect yields to continue to move higher across the European bond market landscape. Inflation expectations in Europe are too low. We continue to expect the U.S. dollar to keep up its poor performance in 2018 and over the coming years.



IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.