Week in Review
The S&P 500 officially entered correction mode this week, pulling back approximately 10 percent from the January highs. It was the worst week for stocks since August 2011. Interest rates remained stable as the supply of government bonds continued to increase with tepid demand. This is only the beginning of a pending $1.0 trillion of U.S. Treasuries coming to market in 2018.
Fire and Fury
Volatility has reared its ugly head the last few trading days, with investors and talking heads alike searching for answers as to why. There are a lot of reasons amid the speculation: leveraged ETFs (i.e., the XIV), rising inflation and Federal Reserve tightening, among others. What is known is that this drawdown should not be a surprise. We have been living through one of the least volatile markets in history. Historically, markets will move 2 percent on any given day at least 15 times a year, and up until this week we hadn't seen that since September 2016. We typically see at least a 10+ percent drawdown as well in any given year and until last week we hadn’t seen a 10 percent drawdown since January 2016. This period of calm has led investors to complacency, resulting in the increasing likelihood of a pullback.
What we do believe, is this pullback is just a normal selloff, and not an indication of a slowdown in the economy. Investors, while selling stocks, are not fleeing to safety in bonds as they have in other correction periods. The chart below highlights four periods of market uncertainty in the past few years: China Growth Scare One (August 2015), China Growth Scare Two (January 2016), Brexit (June 2016) and this current period.
In the first three instances, investors bid up bonds, thus driving interest rates lower due to fears of a potential economic slowdown. In this selloff, bond yields have risen. The fears of inflation and rising interest rates are weighing on investors.
We aren’t as concerned about rates moving higher. A pick-up in inflation due to accelerating economic growth is a positive. However, it does result in an overhang of pending Fed actions. We saw that in 2013 when the Fed indicated they would stop their purchase of government securities, which resulted in the yield on the 10-year U.S. Treasury rallying and volatility in stocks increased. However, as the chart below shows, stocks eventually followed yields up as investors viewed this instance as a positive for the economy and markets.
Therefore, we would not be selling this weakness, rather opportunistically putting excess cash to work. While the selloff has been fast and furious, we believe more time is needed to digest the move.
The risk we see is the potential for the Fed to tighten in an aggressive way. At this time, we don’t believe it will happen; however, the continued weak dollar, a late-cycle tax cut and increasing fiscal spending may push inflation above the Fed’s threshold.
Finally, we will finish with some words of wisdom from well-known mutual fund manager Peter Lynch: “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
Takeaways for the Week
- Markets were due for volatility
- Economic growth remains supportive of corporate earnings; thus, we believe this drawdown will be short lived