By: Francis P. Rybinski, CFA, Chief Macro Strategist and D. Harris Kere, CFA, Investment Strategist
February and March's sharp equity selloffs have many asking if surging volatility spells the end for the equity bull market. We think this begs the question. Market turbulence is likely to be higher in the future than in the past, but supportive fundamentals should keep the overall returns trend positive.
Volatility events tend to cluster, and it can take weeks for financial market prices to recalibrate and revert to trend. This alone may be reason enough to be on the lookout for continued volatility. But when coupled with the evolving monetary policy and interest rate environment, the near future looks much more amenable to more frequent price swings than the recent past.
More volatility coming?
The tug-of-war between the pace of changes—in realized or expected real activity relative to inflation or expected inflation, or between rising earnings and rising interest rates—may be a major factor on equity valuations in the short term. We're likelier to observe more equity volatility, rather than less, with the return of higher volatility implying lower Sharpe ratios in the future than what was recorded over the last year. This is not necessarily bearish US equity risk; returns should still be constructive in the current macro backdrop, as long as two conditions hold: (1) the 10yr yield doesn't jump higher and breach levels at which the trend correlation between equity prices and treasury yields is negative; and (2) fundamentals do not deteriorate.
One way we view financial market volatility in the context of macroeconomic activity is illustrated in Exhibit 1. We aggregate excess returns over cash for financial instruments—2-year and 10-year US Treasuries, corporate bonds of varying credit quality, the S&P 500 and the US dollar index—to show a standardized volatility of risk assets. This measure typically corresponds well over a long period with activity in the real economy, which we proxy with the Chicago Fed's National Activity Index (CFNAI). Financial market volatility was particularly depressed, relative to economic activity, heading into February's equity selloff. The effects of quantitative easing were a likely contributor to the undershoot. More generally, specific shocks though time can be readily observed. Most recently a crisis of confidence in early 2016 and a return to justified trend following an oil-induced correction. Equities had been a leading contributor to the volatility undershoot throughout 2017, but may now be leading the charge back to justified trend.
Exhibit 1: Financial markets and the real economy
Sources: Chicago Fed, Bloomberg, Barclays, Aegon AM Macro Strategy. As of Jan 2018. Note: z-score is the number of standard deviations below or above the population mean
There are additional factors to consider as this enduring business cycle is set to meaningfully outpace its potential, aided by an uncharacteristic late-cycle fiscal boost: namely growth & inflation, and market technicals.
Growth & inflation
In recent years, the equity risk premium has compressed while increases in earnings growth rates have outpaced increases in Treasury yields, lowering the discount rate for equities and increasing equity valuation levels in the process. Growth may no longer be the dominant factor going forward as solid growth expectations are now met with the prospect of higher yields given the advanced age of the cycle and a pick-up in economic activity, with marginal changes in either factor impacting the cost of equity and equity valuations. This may prompt more frequent re-pricings as investors exhibit an increased sensitivity to single data point surprises.
These short-term dynamics will likely give way to a medium term macroeconomic see-saw between the Federal Reserve and the real economy, balanced by late-cycle fiscal stimulus on one end and the potential for monetary policy mistakes on the other (2018 Macro and Rates Outlook). Depending on how this scenario unfolds, the environment may eventually be less constructive for equity returns.
Concern over rising inflation is one element that's recently put the bull-run at risk. However, 10-year inflation breakeven levels—market-based measures of inflation expectations—are not yet sounding the alarm over the serious inflation risks that would typically mean trouble for the real economy and equities.
Equities have borne the brunt of the surging volatility, the magnitude of which suggests that technical factors and the economics of the asset class exacerbated the correction. Indeed, beyond de-risking in volatility targeting and short volatility positions, listed ETFs, as a fraction of listed companies, are growing at a frantic pace, as are ETF's share of market cap and overall trading volume. Passive funds received multiples of the assets active strategies did last year.
Fundamentals matter most
Robert Shiller's famous cyclically-adjusted price-earnings ratio (CAPE) shows that valuations are elevated, but not yet 20% above levels justified by macro fundamentals, which exhibit 2 illustrates is historically a good indicator of an overbought market. Additionally, rising earnings due to healthy global growth and the late cycle fiscal push in the US may offer broad support to valuation levels near term. Fundamentals haven't worsened, and we don't think they are about to, so the balance of macro factors still points to a constructive environment for equity returns amid higher overall, and more frequent bouts of, volatility.
Exhibit 2: S&P 500 cyclically-adjusted price-to-earnings (CAPE) ratio
Sources: Robert Shiller, FRB, CBO, BEA, AAM US Macro Strategy. As of March 2018
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