U.S. Stocks Fall into Correction Territory, But Investors Should Keep Their Chins UpLearn more about this firm
Investors worried about wage and inflation data should appreciate the underlying strength of the economy, not to mention strong corporate earnings. The market volatility is creating better entry points for longer-term investors.
Investors could be forgiven for scratching their heads and hitting the sell button. Toward the end of last month, which was shaping up to be the strongest January for U.S. stocks in decades, total equity market capitalization stood at nearly $32 trillion. But stronger-than-expected wage data in early February sparked concerns that the U.S. Federal Reserve would raise interest rates faster, and potentially to higher levels, than previously expected. That caused a spike in volatility, forcing at least a few short-volatility exchange traded notes (ETNs) to exercise “exploding options” and liquidate, compounding the broad market selling.
A subsequent recovery proved short-lived: a week after the wage data, major U.S. stock indices had fallen into correction territory, down just more than 10% from their January highs, and lost around $2.5 trillion of market capitalization. “People fear the economic data are so good, they’re bad,” said Thornburg Portfolio Manager Charles Wilson, PhD, noting that the fear of Fed rate hikes was sweeping the market. Generally, more aggressive Fed tightening risks pulling the rug out from under the economy and tipping it into recession. But investors would be well-advised to refrain from indiscriminate selling. Moderately paced rate hikes, which the Fed has consistently signaled are its aim, aren’t necessarily negative for stocks or even riskier high-yield bonds if economic fundamentals are strong. And arguably, they are strong, both in the U.S. and globally. The International Monetary Fund reckons global growth will accelerate this year to 3.9% from 3.7% in 2017 and 3.2% the year before, while it’s penciling in U.S. expansion of 2.7% in 2018, faster than the estimated 2.3% growth in 2017 and 1.5% in 2016.
U.S. stock market valuations, which had been running at their highest levels since the financial crisis, just got a little less demanding, even as first-quarter, earnings-per-share estimates for S&P 500 Index companies in January rose 4.9%, marking the biggest estimate increase in the first month of a quarter since FactSet started tracking the data in 2002. Outside the U.S., MSCI EAFE Index earnings per share estimates are also rising but are still far from peak levels. The same is true of MSCI EM Index EPS estimates.
The market may also be a bit nervous about the new Fed chairman, Jerome Powell, who took over from Janet Yellen on February 5, when the Dow Jones Industrial Average marked its biggest-point decline on record. Although Powell never dissented from any monetary policy decision since becoming a voting member on the Federal Open Markets Committee in 2012, investors may be worried that he won’t sustain the Fed chief “put.” It’s a moniker attached to his predecessors, Alan Greenspan, Ben Bernanke, and Janet Yellen, to imply that the Fed wouldn’t tighten monetary policy so much that a bear market in stocks could take hold.
If Powell hasn’t said much about the market lately, Fed Bank of New York President William Dudley did tell Bloomberg News on February 8 that the expectation of three Fed rate hikes this year “still seems like a very reasonable projection.” He suggested that the fall in equities doesn’t have meaningful implications for the economy, but noted that continued declines might hit consumer spending. So far, though, the stock market drop “is small potatoes,” he added. The S&P 500’s total return over the last year still amounts to nearly 15%.
Long-term rates, Dudley added, have climbed partly because “monetary policy around the world is going to become less accommodative” as “the global economy is growing quite quickly,” and financial markets are simply adjusting. That includes higher yields in the bond market, which are also pressuring equities. Interestingly, the U.S. 10-year Treasury bond yield rose to around 2.87%, its highest in four years, as the market anticipated a heavy issuance schedule as the recent U.S. tax reform will likely deepen the budget deficit. Rising deficits juxtaposed with a strong economy that supports high yield fundamentals may be why the spread between U.S. high-yield bonds and Treasuries of similar maturities actually shrank about 10 basis points over the last few sessions. Though at 3.21%, it still remains highly compressed relative to its 20-year average of 5.32%. Default rates remain relatively low.
That, of course, could change if the Fed does move faster than expected, raising debt servicing expenses and the cost of capital, reducing credit, and potentially undercutting earnings growth if consumers or businesses pull back. But one thing is more likely than not, the generally very low levels of market volatility in recent years are likely behind us for now as monetary policy in the U.S. and abroad becomes less accommodative.
Long-term investors needn’t worry about short-term market volatility, particularly after a calendar year in which it mostly sat at record lows. To the contrary, it may be moving back to more normal levels. Besides, market corrections present opportunities to upgrade portfolios by picking up stocks with strong fundamentals at better price points.
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