What has changed in equity markets?

John Swarr

By John Swarr | May 3, 2018

The U.S. equity market had strong performance and low volatility in 2017, which continued through January this year. This trend ended the first Friday in February when Average Hourly Earnings surprised to the upside, signaling rising wage inflation and stirring fears that the Fed would continue increasing the Federal Funds rate and tightening monetary policy. Since then, the equity narrative has shifted from the low volatility and easy financial conditions that fueled synchronized global growth in 2017, to rising inflation and input costs and tighter financial conditions threatening to derail the current economic expansion. Earnings seasons will have been well underway at the time this write up is published. Although earnings have been very strong across the board, the stock market performance has been lackluster. This week’s chart outlines several developments this year that are contributing to the changing landscape for equity investors.

Increased volatility – A major story in 2017 was the historically low levels of volatility in equity markets. As I wrote in December, selling volatility – betting that markets will remain calm – became a successful but crowded strategy that helped suppress day-to-day market movements. On February 5, CBOE’s Exchange Volatility Index (VIX) doubled and wiped out billions of dollars betting against an increase in VIX. This event brought some normalcy back to volatility markets, and we have seen larger daily movements in equity indices since then. Higher realized volatility has made equities a less attractive investment on a risk-adjusted return basis this year.

Tightening financial conditionsAfter almost a decade of zero interest rate policy and balance sheet expansion by the Federal Reserve, monetary policy has started to tighten as the Fed continues increasing its policy rate and unwinding its holdings of debt securities. Adding to the cause is the increase in debt issuance by the Treasury to pay for the rising U.S. deficit, which will continue to put upward pressure on interest rates. The effects are starting to flow through the economy in various places. Some examples include increased financing costs for companies with floating-rate debt, and rising mortgage rates for consumers.

Peaking growth expectationsIn addition to rising financing costs, companies are also facing increased labor and input costs. Wages continue to trend upward and commodity prices are well above their 1Q16 lows. Companies unable to pass the cost increases along to the consumer will face tighter profit margins. Headline news has also affected the growth outlook this year, including concerns of a trade war with China and regulation of the tech industry.

 

Key Takeaway

As recently as February, we saw the market shift sentiment on equities. The “buy-the-dip” mentality of yesteryear has shifted to “sell-the-rally.” The changing landscape has disrupted the smooth grind higher for equities. Despite the concerns, many of the tailwinds in the economy have not subsided quite yet. Job growth and corporate earnings remain strong, and household finances continue to improve. The full effects of tax reform and the $1.5 trillion infrastructure plan proposed by the White House this February could still provide an additional boost to the economy.

The more important shift of this year may have been a “pricing-out” of some of the good news from last year, and a “pricing-in” of newer concerns. For the bull market to continue, I will be looking to see if the market finds new developments to feel positive about to offset some of the recent concerns.

 



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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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