Volatility looms despite the recent recovery in equities

David Joy – Chief Market Strategist, Ameriprise Financial
Weekly markets commentary — Feb. 20, 2018


Global equity markets extended their recovery last week, in a powerful move that was almost as swift as the downdraft of the previous two. The S&P 500 index rallied 4.3 percent, building on the rally that began the previous Friday, and in the process halving its decline from the January 26 peak to 4.9 percent. The MSCI All Country World index made a similar move, rising 3.6 percent in local currency terms. The VIX index, which had spiked from 11 to as high as 50 during the market spasm, receded further, ending the week at 19.5, near its long-term average. 

Although stocks have not fully recovered their lost ground, and may well re-test technical levels of support, last week’s move higher reinforces the view that the correction was more episodic than structural, triggered by those caught on the wrong side of the volatility trade rather than any fundamental change in the generally positive backdrop for the economy and earnings. 

That is not so say, however, that there are no concerns. What set-off the dislocation in volatility in the first place was the acceleration in bond yields, driven by hints of rising inflation and expanding debt supply, which very much remain. When stocks peaked on January 26 the yield on the ten-year note was 2.66 percent. It ended last week at 2.89, down only fractionally from the peak of 2.91 last Thursday. So, while those who were short volatility were rudely forced to come to their senses, the cause for that rude awakening, namely higher bond yields, is still very much with us.

Consumer prices on the rise

Consumer prices rose 2.1 percent over the previous twelve months in January, the same pace as in December. The core rate was also unchanged at 1.8 percent. The headline rate has been relatively stable over the past five months, but the core rate has edged modestly higher. The 0.3 percent increase in January was the most since March, 2006. And lurking ominously ahead is the March report, which will push last year’s -0.1 percent monthly reading out of the trailing twelve-month calculation. 

In her prepared remarks at the press conference following the Federal Open Market Committee (FOMC) June 2017 meeting, then Chair Janet Yellen said, “The recent lower readings on inflation have been driven significantly by what appears to be one-off reductions in certain categories of prices such as wireless telephone services and prescription drugs. These prices will, as a matter of arithmetic, restrain the twelve-month inflation figures until the extraordinarily low March reading drops out of the calculation.” Even beyond the March decline, every other core inflation reading between April and July of last year rose by just 0.1 percent. In contrast, the most recent six monthly readings have been averaging closer to 0.2 percent.

Investors assess what rising bond yields mean for inflation

Rising bond yields reflect the concern regarding inflation, as investors assess what it means for Fed policy. Currently, fed funds futures suggest that investors believe there is only a roughly one-in-three chance of three quarter point Fed rate hikes this year. However, with a current effective fed funds rate of 1.42 percent, the two-year treasury note yield at 2.19 percent seems less conflicted about the likelihood of three rate hikes.

Investors are also wrestling with the implications for treasury supply from the recently enacted tax cuts and budget agreement. The administration is counting on robust economic growth to keep the deficit in check. In the four years immediately ahead, the administration forecasts average growth of just over 3.0 percent. In contrast, the Philadelphia Federal Reserve’s Survey of Professional Forecasters anticipates average growth over the same interim of 2.25 percent. The FOMC’s median forecast for 2018 is 2.5 and for 2019 is 2.1 percent. The central tendency long-run forecast calls for growth of 1.8-1.9 percent.  

How much this will matter in the short-run, with earnings expected to remain robust, is uncertain. Factset now estimates fourth quarter earnings growth at 15.2 percent, the fastest pace since 2011, and 17.9 percent growth in 2018.