investment viewpoints

Equity sell-off: Bear beginnings or necessary correction?

Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist
Charles St-Arnaud - Senior Investment Strategist

Charles St-Arnaud

Senior Investment Strategist
Jamie Salt, CFA - Systematic Fixed Income Analyst and Portfolio Manager

Jamie Salt, CFA

Systematic Fixed Income Analyst and Portfolio Manager

Key points:

  • Inflation is, to us, the sleeping giant threatening to derail “Goldilocks”
  • An equity market correction  is unsurprising after a period of exuberance, but technical factors exacerbated the move
  • Macro fundamentals remain supportive for equities, but investors to beware of the return of volatility
  • We favour European and emerging markets equities; remain negative duration risk

Global equity markets are going though one of their worst performance in recent years, erasing most of the gains since the beginning of the year. The decline in equity market has also spilled over to other asset classes: a sharp increase in volatility, as measured by the VIX, a decline in most commodity prices, a widening in credit spreads and a decline in government bond yields.

In our December outlook (2018 outlook: Big Bang or Steady State), we laid down our view that 2017’s perfect “Goldilocks” scenario – broadly solid economic growth and subdued inflation - is unlikely to be repeated in 2018. From a fundamentals perspective, inflation is, to us, the sleeping giant. Our view has been for some time that 2018 would be the year where inflationary pressures would make a comeback in the US as economic slack in the US erodes and challenge “Goldilocks”.

The big question looming on many investors mind is: are we entering a secular bear market or a market correction after months of positive return?

Reasons for the sell-off

To assess whether the current sell-off has the potential to develop into a secular bear market, it is important to understand its drivers. We believe that the current market downturn can be explain by three main factors:

  1. Profit taking. Investors that have been holding equities for some time are sitting on large profits after a year of ‘hyper’ returns. It is likely that at some point some of those investors would have been tempted to materialise those profits.
  2. Higher rates. Interest rates have been on the rise over the past months as the market gradually came to recognise that the Fed would continue to normalise monetary policy. US 2-year yields have increased by almost 90 basis points since September. In addition, the long end of the curve has also moved significantly - about 80 basis points over the same period for 10-year yields. Interestingly, this movement is mainly the result of increased inflation expectations, not real yield. This increase in yields and inflation expectations is leading investors to question the sustainability of the “Goldilocks” environment.
  3. High valuation. Equity valuations were already stretched, especially in the case of US equities. As such, it is interesting to note that the dividend yield on the S&P 500 fell below the 2-year government bond yield earlier this year, reducing the attractiveness of US equities relative to bonds. Nevertheless, in Europe, the dividend yield on the Euro Stoxx remains well above European bond yields.

These factors created the initial sell-off that we saw on Friday and at the beginning of Monday. However, we believe that the decline in the equity market suddenly accelerated in second half of Monday’s session because of the liquidation of short volatility positions.

Many investors had taken short volatility positions in the past months, earning a positive carry as long as volatility remained low. However, as the market sell-off begun, volatility (as measured by the VIX) started to rise. At some point, stop loss levels on those short volatility positions were triggered, generating a massive covering of those positions, which is often done via the purchase of VIX and the selling of the equity index. In addition to these short covering flows, technical levels on the equity market were reached, triggering further selling. This explained why the VIX exploded higher at the same time the S&P 500 dropped.

Investment implications: still positive for equities

Despite the sharp sell-off in equities, the fundamental macro backdrop remains positive. Interestingly, while the US market saw one of its worst decline in recent years, economic data released showed that the US economy remained strong, with the ISM non-manufacturing index improving to 59.9, its highest level since 2005.

With growth remaining solid in the US, Europe and globally, and central banks remaining vigilant in their removal of the policy stimulus, we believe conditions remains positive for equity markets. However, with inflation expectations increasing and inflationary pressure gradually building up, especially in the US, volatility in equity markets is likely to be higher than it has been in recent years. We continue to see value in European and emerging market equities. Emerging markets are still in cycles around 2 to 3 years behind the US, and we believe that the correction will offer better entry point for investors.

We also remain negative duration risk as we think the rise in US treasuries will resume, as markets continue to incorporate rising inflationary pressures from a tighter labour market, higher commodity prices and a weaker US dollar. At this point, we believe that the pace of the increase in rates is more important for risky assets than the general direction of travel.

Lastly, the current market sell-off should remind investors that in the current environment, where the business cycle is more mature and higher volatility may be here to stay, having an explicit drawdown management when it comes to portfolio construction is essential. 

CNBC - Salman Ahmed comments on sell-off
BFM - Charles St-Arnaud commente la baisse de Dow Jones

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