The spike in market volatility experienced in early February started to fade over the past couple of weeks and major stock indices have retraced 50% or more of their recent pullback. Given market volatility consistently remained at very low levels for an unusually long stretch (18 months) until late-January, we believe market positioning became unbalanced over the past year-and-a-half, leading to the sudden 10% correction a few weeks ago. However, we see this weakness as transient, set against a strong medium-term outlook for market fundamentals. In particular, economic growth momentum remains solid with economic data continuing to beat economists’ forecasts, leading to growth forecast upgrades for this year and next.
Following a sharp rise in the year-to-January 26th (7.5%), equity markets have witnessed an extraordinary rise in volatility over the past few trading sessions leaving most major indices down 1%-5% on a year-to-date basis. From its recent highs, the S&P500 index has dropped 7.8% on an intraday basis. The past few months have been characterized by steadily rising markets with few notable losing sessions and unusually low volatility. Typically, equity markets experience one or two corrections of at least 5% per year as witnessed in the period 2012 to 2016 (see Chart 1). However, up until late January 2018 the S&P500 index had not experienced a correction exceeding 6% since mid-2016. Moreover, a double-digit percentage drawdown last appeared two years ago in December-2015/early-2016 (-12.9%). Thus, the sharp rise in volatility and rapid correction in global markets witnessed in the past few days has followed a very long stretch of unusually low volatility and a lack of profit-taking-driven selling. As volatility spiked in recent days, many investment managers found themselves in need of unwinding large investments (and/or short positions) leveraged on the view that the unusually low volatility environment of the past few months would continue, which significantly added to selling pressure in global markets over the past 24 hours.
Global markets are off to an impressive start to the year with the S&P500 index posting a 6.2% year-to-date gain while the S&P/TSX Composite index is up 1% in the same period (local currency terms). Meanwhile, WTI crude oil prices have climbed 6.7%, gold is 2.7% higher, and the Canadian dollar has appreciated 1% thus far in 2018. In large part, these gains are driven by strong and improving fundamental drivers including accelerating global economic growth, stable inflation, gently rising interest rates and bond yields, recovering commodity prices, a softer U.S. dollar, and healthy earnings growth.
- Macro scenario for 2018. Global purchasing managers’ index [PMI] momentum moderating, EPS growth slowing to high single digits, and yields rising. Recession probabilities remain low; inflation upside could spark volatility.
- U.S. 10-year Treasury yields. Upside risk to fair value above 3%, core consumer price index (CPI) up >2% (1.8% now).
- U.S. dollar: more modest losses in 2018 (U.S. Dollar Index [DXY] -10% in 2017). DXY range of 90-95 (now 92) as U.S.-EU yield spreads narrow. C$ trades around US$0.80 in 1H/18.
- WTI crude oil averaging >US$58/bbl in 2018; Gold benefits from fading PMIs in 2H/18.
- Recommended asset mix. Equities > Bonds preference intact, but with declining conviction. Rising yields + fading PMIs = less-attractive equity risk/reward outlook.