Elevated valuations, investor complacency and the prospect of faster-than-expected inflation combined to trigger the equity selloff this week -- but with economic fundamentals still solid, our investment managers counsel patience amid the current volatility.
ClearBridge Investments: Treasury yields have been steadily rising since September -- and until late January, equity markets had been digesting this move with little trouble. However, a spike in interest rate volatility over the last two weeks, exacerbated by strong wage inflation data from the January jobs report, has led to the largest equity sell-off in two years. Average hourly earnings came in at 2.9%, the highest level since 2009, causing some to question if inflationary pressures are about to rise, and whether the Fed may be behind the curve.
In our view, the market has overreacted to these events. We believe the real culprit behind the recent sell-off has been investor complacency. Prior to last week, the market had not seen consecutive daily declines for 310 days. Further, the record streak of days without a 5% correction was only broken yesterday. These types of streaks are rare and typically followed by heightened volatility as fear begins to percolate back into investor minds.
With complacency the real driver behind the equity sell-off, we believe the market can handle somewhat higher rates in the coming months as long as the ascent is not too rapid.
Royce: Main Street and Wall Street do not always walk hand in hand: we see this as the main lesson from the current overdue pullback, which seemed all the more inevitable after the strong start to 2018. The immediate trigger seems to have been better-than-expected employment and wage gains last week. In this case, good economic news led to bad market news. This counterintuitive relationship may continue.
Of course, other related factors may have also come into play. As is often the case, it was likely a confluence of events, ranging from rising inflationary expectations, higher bond yields, fears of an overheating economy, and overall investor complacency. After all, it has been more than 700 days since the last 10%+ correction in the Russell 2000 Index. Prior to the current sell-off, the largest small-cap decline had been 6.4%, which occurred in September 2017. The large-cap cycle is even older, dating back to the March 2009 low following the Financial Crisis.
It is always important to remember that stock market corrections come and go—they are as inevitable as they are unpleasant and, we believe, ultimately healthy in the context of this particular small-cap market cycle. Investing during painful declines can be one of the most effective ways to build strong absolute long-term performance. We do not know where or when we will reach the bottom of this correction. Every day, however, we seek to take advantage of its dislocations to build strong absolute long-term returns. In an environment characterized by higher volatility and lower returns, discipline and selectivity will be essential.
As small-cap specialists, we continue to believe that performance in the asset class will be driven by three factors: a preference for profitability, relatively lower valuations for both cyclicals and value stocks, and burgeoning economic strength at home and abroad. Being less yield sensitive, cyclicals potentially gain an additional advantage in a new era of rising rates.
Our outlook for small cap stocks remains mixed: we think the index will deliver lower returns over the next 3-5 years than it has more recently, while we also see great opportunities with selective small-cap stocks.
QS Investors: People are waking up to the real possibility of interest rates rising at a faster-than-expected pace on the heels of the hawkish tilt in last week’s FOMC statement, concerns that inflation may be moving closer to the Fed’s 2% target as a result of strong wage growth numbers, and Jerome Powell replacing Janet Yellen as Chair of the US Federal Reserve.
We believe higher interest rates are the main driver of negative sentiment in equities. Rising interest rates typically increase borrowing costs for businesses and offer investors more attractive yields than stocks, making equities less attractive than bonds on a relative basis. Markets priced in this logic quite heavily over the last few days and it looks like this sentiment could continue.
For US Treasuries, it has been an interesting ride since last week. Following the January 2018 employment report, yields rose across the curve on increased inflation expectations, as one would expect. However on Monday, yields declined more than 10bps due to the “risk-off” asset rotation into US Treasuries and the covering of duration shorts.
While our views have slightly shifted amid the volatility of the last week, changes in our asset class model views are not as dramatic as what we have recently observed in the market as most of the fundamentals have not changed and our models are based on longer time periods.
Our view on stocks vs. bonds is in neutral and currently close to a 12-month low, after strongly favoring stocks throughout 2017. The main driver of our change in sentiment towards stocks has been our QS Leading Indicator Index, which has declined as a result of a significant drop in global trade activity and in spite of favorable labor market and manufacturing activity. In addition, rising interest rates and a slight tightening of credit conditions in the economy have also weakened our sentiment towards stocks. Rising interest rates also affect our relative valuation of stocks and bonds, while stocks, still more attractively valued than bonds, with higher bond yields the valuation spread between stocks and bonds, has also narrowed.
More generally, it is challenging to predict when volatility will strike, even with positive fundamentals. We believe that a well-diversified strategic asset allocation that includes exposure to defensive equities, may help provide a measure of comfort by seeking enhanced stability while maintaining equity market exposure and the potential for further gains.
Martin Currie: Since October, the first signs of inflation ticking up prompted many commentators to speculate that the withdrawal of liquidity and monetary policy tightening might be implemented sooner than had previously been expected. Bond yields responded with a move higher and this has accelerated in January, the US 10-year Treasury yield jumping from 2.41% at the start of the year to 2.85% at its peak on 2 February.
This brought about a growing fear of a disorderly bond market sell-off and contagion into equity markets causing volatility to pick up from benign levels as the selling increased. Why? Higher bond yields translate into a higher price of risk used to value all other asset classes and ultimately an increase in the cost of doing business. When the really heavy selling started on Monday, no sector or style in the US won out, with the exception of utilities and REITs which have been excessively lagging the market for a very long time.
The risk is for contagion worsening from here. Selling has so far been centered around retail investors and we are yet to see large institutional long-only equity holders really step into add to the selling pressure. To us, not much has changed. Global economies are strong and bond yields are higher with an equity market that looks cheaper than six to eight days ago. In fact, the move lower in markets could be viewed as a necessary correction.
We expect markets to stabilise shortly and opportunities will arise for those that have missed decent returns over the past few months to buy cheaper growth stocks. We will certainly look carefully for any opportunities.
We feel sure that this period of volatility at the closing stages of a record bull market will not be the last, but we are not entering a sustained market reversal just yet.
Brandywine Global: 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. However, 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? 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.
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.
RARE Infrastructure: What triggered the recent volatility? Most likely the rapid rise in bond yields. This has been largely contained to the Treasury market +45 basis points year-to-date for 10-year Treasuries), with corporate yields remaining relatively well behaved --likely because recent tax reform is credit-positive for most corporates. Please note, however, this is not the case for utilities, and could have added to their weakness. Furthermore, the market “got ahead of itself” and the calls from strategists for a pullback were increasing.
What are the implications? Infrastructure assets are set to grow by 124% and exceed USD $110 trillion by 2030. Listed infrastructure investors who take a long term view can enjoy the attractive characteristics of the infrastructure asset class which includes: long-term stable cash flows, lower correlation and beta to other asset classes and inflation protection while enjoying the added benefits of listed markets such as liquidity and lower fees.
Does this impact our view of the markets? We currently view the sell off as a short term phenomenon. RARE retains our long-term convictions in our current exposure to utilities and, where appropriate, will seek to take advantage of the recent mispricing and to invest where we, as active managers, see value.
Clarion Partners: Private commercial real estate tends to be insulated from high volatility moments such as the one we are witnessing impact global public equity markets. The major caveat is, of course, that such moments are not a precursor to a broad-based cyclical downturn. Real estate fundamentals are still favorable. The direct and indirect benefits to the industry from tax reform has extended the positive momentum in space demand. Supply growth has risen but remains a fraction of prior industry cycles. Lenders have remained conservative owning to the constraints of post-crisis financial regulation.
Furthermore, while core real estate performed in line with industry expectations it paled in comparison to public equity benchmarks like the S&P 500 and Dow Jones Industrial indices. More than two-thirds of the 2017 annual total return is attributable to income as opposed to price appreciation – a pattern that conforms to core real estate’s long-term behavior. Real estate pricing is in line with fundamentals, and we do not see any reason that the volatility in public capital markets related to sentiment will carry over meaningfully to our industry.