On Monday, February 5, the Dow dropped 4.6%, building momentum over the previous week’s decline and effectively erasing January’s robust market gain. Only time will tell whether the sell-off is done or deepens into correction territory. But with the market’s “fear gauge”—the VIX—shooting upward by more than 100% relative to 2017 levels, it’s worth taking a moment to put the current market turbulence in context.
Volatility is a normal part of the market cycle
First and foremost, this is not an aberration, even if the broad market sell-off worsens. Global equity markets were due for a return of volatility. The only truly surprising thing is that the dislocation didn’t happen sooner. In 2017, the largest drawdown peak to trough was a relatively mild 3%. As our Market Intelligence chart shows, the average intrayear drawdown in non-recession years has been almost 12%.
Inflation frightens Goldilocks
But what is driving today’s volatility? In our view, the problem is that the “Goldilocks” economic narrative that has been the key to investors’ sustained risk appetite may be in jeopardy. Growth and inflation have been neither too hot nor too cold, and this had kept the Fed in a gradualist rate-raising mode, which resulted in stock-multiples expansion. Now that narrative could be shifting, as the new Fed Chair Jerome Powell must consider some decidedly “hot” data from the past couple of weeks, including:
- Higher-than-expected wage growth—average hourly earnings grew by 2.9%, according to the jobs report of February 2
- Rising inflation expectations—10-year Treasury inflation-protected security breakevens, which are frequently read as inflation barometers, have steadily increased to 2.11%
- Higher GDP estimates—the Atlanta Fed’s GDPNow, which offers a model-based growth “nowcast,” indicates a blisteringly fast current GDP growth rate of 4.0%, as of February 6, 2018
A stronger-than-expected Institute for Supply Management services reading on February 5 may have added fuel to the fire. If Goldilocks is gone and the economy is at risk of overheating, the uniformly upward market trajectory is likely over, rapid Fed action could be around the corner, and a repricing of risk assets would be a logical—and potentially healthy—outcome.
Of course, the Fed may want to hold off on raising rates to avoid exacerbating equity market volatility. The Fed paused, for example, in the wake of the Brexit vote and following the China/oil-induced selloff in the first quarter of 2016. However, Powell may not have much of a choice if inflation rises meaningfully. Consumer Price Index data scheduled for release on Valentine’s Day will be an important signal to watch.
Some historical parallels
Current market conditions may be staging a repetition of some not-too-distant history—2003, the year of the Bush tax cuts. One month following the Bush tax cuts, the yield on the 10-year Treasury rose 150 basis points in the ensuing six weeks. Markets fell sharply as a result—the S&P 500 Index dropped 4.5%—but it wasn't the start of a long-term bear market. As yields stabilized, stocks resumed their upward bias, rallying 15% over the next four months.
The earnings growth backdrop of today also bears a strong resemblance to that of the Bush tax-cut period. In 2004, earnings accelerated in the wake of the tax cuts to 20% year-over-year, but multiples contracted. The S&P 500 Index ended 2004 with a gain just shy of 11%. While earnings may well continue to rise in 2018, multiples may contract. That means equity market returns could still be positive this year, but would likely be less spectacular than the market gains of 2017.
Although there are risks and rampant uncertainty, we would say this is no time to panic. Remember that the economic backdrop today is supportive of a healthy market environment. In addition, the recently steepening yield curve is as good an indicator as any that the likelihood of a recession is low. The current sell-off, while painful, may usefully remove some of the market’s froth, potentially reducing the intensity of future market corrections.