If you forgot what it was like to invest in an environment with high volatility, February reminded you. Whereas there were just eight days in 2017 that the S&P 500 moved more than one per cent in either direction, there have been 12 of those days so far in 2018, and 10 of them occurred in February.
Many market participants have occupied their time trying to determine what caused the heightened volatility and sharp pullback in equities, pointing the blame at volatility-linked investment products and worries that the Federal Reserve will accelerate the pace of interest rate hikes. The 10-year U.S. Treasury bond also climbed to 2.84 per cent for the first time since early 2014, and data showed annual wage growth of 2.9 per cent in January, demonstrating that not only is economic growth improving, but higher inflation may also be on the horizon.
“The real struggle the market is grappling with is how to invest in a period of increased growth as we exit a sustained period of low growth since emerging from the Great Recession,” said Lindsey Bell, investment strategist at CFRA Research. “Higher interest rates and higher levels of inflation are normal in an improving economy, but the speed at which those rates increase needs to be steady and not swift.”
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Despite investors’ concerns, Bell noted that history demonstrates that the S&P 500 can move higher in tandem with interest rates, as long as rates are rising from low levels. In fact, U.S. stocks have posted positive average monthly returns during periods of rising 10-year yields, up until six per cent.
“That is what the reality of 2018 will likely be, in our view – higher economic growth resulting in higher interest rates as the equity market moves higher,” the strategist said. “This is beginning to play out in the stock market as it recovers from recent lows and the relationship of interest rates and economic growth are beginning to be understood again.”
Bell believes the S&P 500 can climb to 2,800 by the end of 2018, as low unemployment, higher wages, rising demand for home ownership, increased capital spending, a healthy consumer, and improving global growth provide tailwinds for equities.
“Volatility may have returned, but it should not be feared,” she said. “We view its presence as an opportunity in 2018.”
Dubravko Lakos-Bujas, U.S. equity strategist at J.P. Morgan, thinks there has been some overreaction to recent inflation headlines.
“We view normalizing inflation and declining global deflationary risks as a positive for equities at this stage in the cycle,” he said, noting that moderating inflation, coupled with wage growth from low levels, has historically led to stronger revenue growth, margin expansion, and asset appreciation.
Rather than blaming the recent equity sell-off on rising long-term rates and inflation fears, Lakos-Bujas believes the market weakness was almost entirely due to technical factors and was therefore disconnected from strong fundamentals.
“While rising long-term rates will ultimately become a negative for profits and multiples, we do not see current levels as a reason to de-risk and sell equities,” the strategist said. “In fact, the recent rise in rates coincided with stronger economic growth, positive earnings revisions/guidance, and expansionary fiscal policy (tax reform and higher government spending).”
He pointed out that the negative impact rising rates has on profits and trading multiples is gradual, as it occurs through factors such as rising interest expenses. The S&P 500’s total debt (excluding financials) is currently around US$5 trillion. Yet with companies expected to deliver double-digit earnings growth in coming quarters, U.S. corporations appear to be in a better position now to cope with a rising rate environment than at previous points in the cycle.
Another driver is the decline in relative valuation support, as income investors rotate out of stocks as bond yields become more competitive with dividend yield, particularly at the end of a rising rate cycle.
However, Lakos-Bujas noted that the leverage spread (earnings yield minus bond yield), is still above the historical average at approximately 163 basis points. That supports the relative valuation argument for equities, and incentivizes companies to lever up their balance sheets through share buybacks, special dividends and leverage.
“In fact, this is exactly what we saw during this technical correction with corporates accelerating buyback programs into the sell-off,” he said. “We expect corporates to remain active with buybacks, which should support markets during sell-offs outside of earnings blackout periods.”