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| February 13, 2018

I can probably count on one hand the number of times in 2017 that I received a news alert on my phone that was prompted by stock market movements. Last week, I needed all five fingers from that hand…and a couple toes…to keep track of the alerts that were piling in. The S&P 500 ended the week down 9% from its record high touched on Jan. 26, bringing it back to where it was in late November 2017. Volatility had returned. More specifically, downward volatility – the kind so few of us like – had returned and had done so in dramatic fashion. In fact, last Monday’s spike in the U.S. equity volatility gauge was literally “off the charts” as evidenced by this graphic from Goldman Sachs and Blackrock. 

Sources: BlackRock Investment Institute, with data from Thomson Reuters, February 2018.
Notes: The chart compares daily moves in the spot VIX and S&P 500 e-mini futures since 2007.

The volatility spike comes at a time when market worries over increasing real bond yields (rather than over rising inflation) have taken center stage. The reason: Market perceptions are adjusting to higher U.S. growth and deficits. Note that this contradicts the consensus view that investors were spooked more so by a rise in inflation expectations following stronger-than-expected wage growth. Our friends at JP Morgan point out that the data say otherwise, as evidenced by the 10-year Treasury Inflation-Protected Security (TIPS) yield.  We’ll spare you the boring details, but suffice it to say that this data shows the recent re-pricing of yields is more reflective of growth expectations than inflation.

Does this expected economic growth portend strong equity markets? There are no guarantees, but we think the environment remains favorable. Regardless, it is important to remember that higher real yields change the relative value proposition of stocks and bonds, raising the bar for equities and other risk assets as investors re-assess risk/reward. In other words, if an investor can get more from a bond, their need to stretch out on the risk spectrum via equities (stocks) is diminished. Regardless, we expect equity investors will continue to be rewarded, and believe that the benign economic backdrop and strong earnings momentum provide a solid foundation for continued equity exposure (in a well-diversified portfolio, of course). While we don’t know exactly when the recently sustained losses will be fully restored, the data shows that equity pull-backs are short and recoveries quick in low macro volatility regimes.