The S&P 500 Index plummeted and on February 5 the CBOE Volatility Index1 (VIX Index)—known colloquially as the “fear index”—suffered its largest one-day rise in percentage-terms. However, we believe this dramatic turn of events should be viewed as having underlying fundamental drivers, not just as a technical selloff.
Economic and Corporate Fundamentals Remain Supportive Of Stocks
Based on our current analysis, we continue to see synchronised global growth and supportive corporate fundamentals. In the United States, for example, the full impact of the recently implemented tax cuts are yet to be felt in practice, even if they may have already been priced into market valuations in the early part of this year.
And although central banks are showing signs of stepping back from stimulus measures, we believe financial conditions more broadly continue to support economic activity and growth assets such as stocks.
Deeply Ingrained Behaviour Patterns Are Somewhat Less Evident
At this point, some seven weeks after the initial spike in volatility, it seems to us as though markets have been slightly slow to embrace the opportunity that the dip presented. The deeply ingrained, almost reflex pattern of “buy the dip” has not yet driven many markets to fully correct the price decline. Some indexes remain close to their February lows. High-yield corporate bonds are still under pressure.
Similarly, volatility remains somewhat higher than it has been in recent years. This isn’t a big surprise to us. Indeed, we have been expecting a normalisation to occur at some point, even if we couldn’t predict the exact timing or the catalyst for the move.
The shift away from unconventional monetary policy, gradual though it is, will likely remove central banks as one of the forces holding market volatility at depressed levels.
Dangers From Trade Wars and Political Repercussions Remain Real
Over the past year, markets seem to have become less obsessed with the regular flow of geopolitical noise. Perhaps we have collectively become desensitised. This might explain the lack of enthusiasm in markets for prospects of easing of global tensions (North Korea comes to mind) or any extended focus on the formation of an Italian government.
However, at least for now, markets are paying more attention to the risks associated with an extension of protectionist policies by the United States and the potential for a wider trade war with China.
The Trump administration in the United States has made it clear that trade is a priority. We’ll wait to see the full extent of China’s response to the latest imposition of tariffs on Chinese steel and aluminium imports. But in general terms we recognise that the tariffs are minor. More importantly, China has become less reliant on the United States as an export destination in recent years, and we expect that trend to continue.
New Stock Market Highs plus Heightened Volatility on the Cards
Looking at the economic backdrop, we think it’s possible that stock markets will make new highs this year, but also that volatility will remain higher than we became used to in recent years.
Given the supportive global economic backdrop, we remain cautiously optimistic about the prospects for growth assets. Even in light of recent market volatility, equity valuations based on price-to-earnings ratios2 in developed markets appear expensive, in our view, and remain elevated relative to their historical averages. However, unless the fundamental attractions of these assets are significantly diminished, the return potential from stocks is more appealing than for developed-market sovereign bonds, in our analysis.
However, the volatility events we experienced in February and March may have lasting portfolio positioning implications for a broad range of longer-term investors.
Any adjustment to higher levels of prospective volatility may tilt the balance within multi-asset portfolios. Similarly, higher bond yields may spur greater demand for assets that more closely match longer-term liabilities. At this stage, we’re continuing to focus our attention on defensive ways to protect against volatility and to capture growth.
The comments, opinions and analyses presented herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.
1. The CBOE Market Volatility Index measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Indices are unmanaged, and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance.
2. The P/E ratio is a valuation multiple defined as market price per share divided by annual earnings per share (EPS).