The global equity sell-off continues this week, which more than wiped out year-to-date gains. The US market is down 10% from its last peak in Jan 2018 and, on Monday 5 Feb, had suffered its worst single-day correction since 2011, with the Dow Jones and S&P 500 Indices ending the session down 4.6% and 4.1%, respectively.
In response, the widely followed CBOE SPX Volatility Index, also known as the VIX, soared as high as 50, hitting its highest level in three years.
Longer term outlook remains positive
We urge investors to remain calm and stay invested.
Despite the turbulence, the longer term outlook for global equities remains positive. This is firmly underpinned by broad-based growth momentum across key economies, with further support to come from US tax cuts.
In fact, for 2018-19, we expect to see the strongest global economic expansion since the last financial crisis, and the risk of a recession remains low.
The correction in recent days is not likely to have a meaningful impact on underlying economic fundamentals, which have been resilient over the growth up-cycle thus far, and our forecasts for healthy corporate earnings remain intact.
After record run, a consolidation is not surprising
Before this drawdown began, global equities had enjoyed the strongest start to any year in almost two decades. It was also on its longest run since the 1970s without a correction of at least 5%. Trees cannot grow to the sky; a consolidation here should not be surprising.
History also shows that corrections in excess of 10% are not unusual – even in bull markets – and these are usually short-lived and take an average of less than six months to recover.
Some headlines have raised alarm that the Dow has never declined over a thousand points in a single session before it did on 5 Feb, but this is only true because of the high base of the index today. In percentage terms, a single-day decline in excess of 4% is not rare for the Dow, and has occurred 27 times since 2000.
Equity weakness closely associated with rise in bond yields
The current weakness in equities is closely associated with the US 10-year Treasury yield rising rapidly from 2.4% to 2.8% over the last month, which caused trepidation as a disorderly surge in yields can potentially have a disruptive impact on both markets and fundamentals.
The move in yields was mostly due to heightened expectations of US inflation, which has been underpriced by the market. We believe that inflation will continue its upward push over the next few months, which will pressure the Fed towards a faster pace of rate hikes than what consensus currently anticipates.
Over the longer term, however, the normalisation of inflation and interest rates is a positive thing. This forms part of an overall picture of healthy demand and growing economic activity, driven by broadly improving fundamentals across consumption, investment and trade. As long as growth momentum stays positive, steady hikes in rates towards more neutral levels are unlikely to derail the positive long-term outlook for equities.
Technical factors exacerbated the pain
Stretched technical factors in the equities market before this drawdown – such as heavy positioning, high margin levels and market sentiment – exacerbated the speed and magnitude of the correction.
As equities fell, we saw limited risk-off contagion across assets classes, and the credit, foreign exchange and commodities markets were relatively well behaved. This suggests to us that a significant part of the equities correction can be attributed to the reversal of technical factors, which may take some time to balance out.
The record surge in volatility also resulted in unusual implications. The popular VelocityShares Daily Inverse VIX Short-Term ETN (XIV US) – which was designed to give a return inversely proportionate to the VIX Index – was wound up after suffering crippling losses as the VIX soared.
High realized volatility also triggered selling from various systematic investment strategies, and we could see more selling pressure from this group over the near term.
Stay invested and be prepared for volatility
With the divide between near-term technical weaknesses and the positive long-term outlook, we believe that fundamental investors are likely to re-emerge as buyers over time as nearer term selling becomes exhausted.
Investors should stay invested, and be prepared for a more volatile market than what we saw last year.Disclaimer applicable to recommendation
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