Despite solid fundamentals, learn from latest market turmoil

Despite solid fundamentals, learn from latest market turmoil
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The February market “tantrum" brought to an end an extraordinary period of U.S. stock market gains that started after the presidential election in late 2016. Through the end of January 2018, the Dow Jones had rallied almost 37 percent in just 14 months.

That was an amazing surge in such a short time; it took the market 45 months to accumulate the same gains in the period prior to Election Day. On its own, the nearly 7-percent sell-off on just the first three trading days of February sounds scary. Yet, markets merely erased the prior month's gains, essentially resetting performance for the year. 

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The apparent catalyst for the sell-off was stronger-than-expected wage growth in last week's U.S. jobs report. Faster wage growth threatens to boost inflation, which isn’t priced into the U.S. Treasury market or the Federal Reserve's inflation and rate forecasts.

 

It was thus no surprise to see bond yields jump higher on the first whiff of inflation risk. That in turn spooked equities, and the correction was off to the races. The growing importance of volatility-based derivative strategies and exchange-traded funds may have contributed to the speed of the sell-off.

It is important to remember, however, that fundamentals have not deteriorated. The world remains in a synchronized recovery driven by improving business investment. The latest purchasing managers’ indexes show no sign that the improvement in manufacturing activity is abating.

Furthermore, the U.S. tax cuts have yet to show up in company profits and household income. Equity markets may have surged too fast in January, but the economy should grow faster this year and corporate earnings should continue to rise.

While it’s easy to dismiss the February sell-off as a temporary correction in an ongoing bull market, there are a few lessons to learn: 

First, the severity of the sell-off supports concerns that stocks are richly valued. That is not the same as saying markets are overvalued. Rather, after a year with a greater than 20-percent return in U.S. equities, investors are more than happy to take some profits. 

Second, the sudden spike in equity volatility is likely a preview of what’s to come as we move closer to a world without quantitative easing (QE). Already, markets have to make do without a more explicit central bank backstop.

The last time we saw a similar sell-off, in August 2015, the Federal Reserve quickly adjusted its economic assessment and added a passage to the next Federal Open Market Committee (FOMC) statement highlighting the risk that “global [...] financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

I doubt we will get that much verbal intervention this time around. In fact, QE is likely to end in mid-2019, when for the first time in nearly 10 years, net-asset purchases by the three major central banks will turn negative. That withdrawal of liquidity should pose a significant challenge to markets and economies. But that’s a 2019 story. 

Third, the severity of the sell-off poses a few questions about the impact of volatility-based strategies that create forced sellers and exacerbate market corrections. Rather than questioning market fundamentals or valuations, we may have to pay more attention to the accumulation of trades based on conventional wisdom.

In 2007, it was the failed assumption that house prices can only go up that greatly exacerbated the market crash. This time, it was the assumption that low volatility is here to stay that was proven wrong. 

At PineBridge Investments, we are mainly fundamental investors. However, we also pay close attention to structural imbalances in the markets that have the potential to overwhelm fundamentals.

It doesn't seem that investors have had enough time this year to build up significant exposure, which should limit this month’s market decline. Hence, this sell-off looks more like a buying opportunity in a world of still-improving fundamentals.

Markus Schomer, CFA, is the chief economist at PineBridge Investments, a private, global asset manager.