Our Initial Thoughts

The market sell-off that began in earnest on Friday 2 February appears initially to have been an adjustment of investor sentiment. Particularly since the passage of significant tax cuts in the US in December 2017, the consensus view of the outlook for 2018 had become rather bullish. Economic growth has been strengthening around the world and corporations have been able to generate significant earnings growth. The cuts to corporate tax rates in the US have turbo-charged the already strong earnings picture.

All this has helped the stock market to record highs but it also helped get investors to be very optimistic. As ever, the market has decided to reward such complacency with a reminder that risk needs to be considered too.

The selloff was particularly significant for volatility focused trading strategies. The persistence of low levels of volatility in the stock market throughout 2017 had made a strategy predicated on that unusual circumstance continuing very profitable. There has been much publicity about exchange traded notes (ETNs) directly shorting volatility that have suffered very significant losses or that have been closed down. But there are other derivatives of such strategies which have also done very well in the last year or so, such as volatility controlled equity funds, which have also seen big losses in recent days.

When these sorts of trading strategies reverse it can induce liquidation both of the strategy itself and of other assets held by investors in those strategies. Given that some of these strategies are rather opaque, the broader investment community is naturally nervous about them and this in turn can exacerbate the selling.

After a prolonged period of a rising market we were all aware that a correction/fall was overdue. Although we see the driver of this correction as being sentiment and trading related, it is important to realise that significant selloffs in the equity market can be an indicator that all is not well in the wider economy. While we agree in the cliché that “the stock market has predicted 12 of the last 7 recessions”, we do need to be alert to any signs that there is a change to the supportive macro backdrop that we have written about in recent reports.

What to look for from here

We remain of the view that the macro backdrop is a supportive one for the equity market. But we must always be alert to the ever changing investing landscape. The things we are looking at closely to determine if there are reasons to alter our constructive view include:

1. Inflation. There has been an increase in some measures of inflation including a rise in the level of hourly earnings for US workers in January. We will watch such data points closely as well as market expectations for inflation from such things as the spread between index-linked and nominal bond yields. At the moment the levels of inflation evident in such measures are consistent with the 2% central bank inflation targets on either side of the Atlantic. Any move above that would be worrying, not least because it would imply that central banks have been too slow to move away from the extraordinarily stimulatory policy seen since 2008.
2. Government bond yields. Related to the above, if the market becomes nervous about inflation and/or about its ability to absorb the significant issuance of US treasuries that will accompany the fiscal stimulus proposed by President Trump, then bond yields could rise more than they have already done. If bond yields are rising while the equity market is falling then investors truly have nowhere to hide. That could in turn exacerbate selling in the equity market. Cash may yield zero, but that is better than suffering declining values in both equity and bond holdings.
3. Credit spreads. Credit spreads have narrowed over this extended cycle of low bond yields which has allowed companies to borrow as cheaply as ever in history. A significant widening of credit spreads would be a negative for companies but would also be an indication that risk aversion was spreading into the other main depository of investor assets.
4. The US dollar. The asset price that particularly matters is the US dollar. A period of appreciation of the dollar would be bad for the global reflation story as it will likely be accompanied by falling commodity prices, weaker global demand and underperformance from the higher beta markets such as emerging markets and Asia (including Japan). That weaker global demand would also likely be a negative for Europe which would offset the benefit Europe will get from a weaker euro under the stronger dollar scenario.
5. Performance of financial equities. We should also watch closely for any signs of stress at financial institutions. Given the extensive use of “short volatility” strategies, bank trading desks may have some nasty surprises. It is almost certainly the case that some of these products will have been mis-sold.

To repeat, we remain of the view that the fundamental backdrop is a positive for equities. The selloff therefore provides a buying opportunity for the long-term investor. But we will be watching the indicators above closely in coming days and weeks and will update you on our views as we do so.

By William Dinning

Head of Investment Strategy & Communication