Why this correction?

Analisi di mercato - 07/02/2018

The equity markets have suffered a sudden correction in recent days, starting with the United States. Volatility is back in a big way, driven by trends on bond markets since mid-December. (English version)

Those trends, in turn, are due to the fact that the synchronised global recovery is causing major central banks to shift their monetary policies or is causing investors to price in such a shift here and now. In addition to the US tightening cycle, which is well under way, the ECB is expected to alter its forward guidance soon to start preparing investors for an initial rate hike. The Bank of Japan’s guidance is not as clear-cut, but still suggests that it could begin a tightening cycle, as well.

Until now, this new perception of monetary policy had only affected sovereign bond yields. But the release of US monthly job market statistics for the month of January has changed the picture, with wages accelerating more than expected. In investors’ minds, if inflationary pressures were to show up, that could undermine plans for a gradual shift to tighter monetary policy, i.e., the central banks would have to tighten faster. And, as their quantitative easing1 policies have inflated asset valuations in recent years, strong turbulence may hit markets.

The equity market drops have been exacerbated by the extent of short VIX2 strategies set up in recent months. Lots of ETFs and other funds have warmed to this theme in an attempt to exploit this windfall, i.e., the strategy is highly profitable except in extreme cases when losses can be considerable. But the strategy has been the victim of its own success, as the return of uncertainty on bond yields has sent equity markets down, thus raising volatility (i.e., the VIX), which has very quickly led to losses. Those strategies have been unwound, boosting the VIX and exacerbating losses for those who tried to hold onto their positions. We found out Tuesday morning that an ETF based on this strategy was shutting down. Some risk parity funds3, whose exposure depends on market volatility in recent months, may also have had to scale back their risks.

For once, US equities did not serve as a safe haven. In fact, they have actually underperformed European stocks. The suddenness of the equity market drop on Monday triggered a flight to quality4, with the 10-year US yield dropping from 2.85% to 2.71% Tuesday morning. This led to a backlash, with the trend towards higher interest rates creating the conditions for lower yields.

Our view

While this correction has gotten everyone’s attention, the good news is that it is being driven in part by technical factors. Equity markets had moved up too fast, and we saw that the markets were becoming shaky. But a more basic question is whether inflationary pressures are back and whether central banks will shift their plans more radically. Keep in mind that monthly wage statistics are volatile and are frequently revised. Not for another several months will we be sure about them. But even if wage hikes do show up in the statistics, there’s no guarantee that such wage hikes will result in inflationary pressures, as they could come with greater productivity or could be absorbed into companies’ margins.

Whilst the inflation debate which helped spark this recent set back is almost certain to continue over the coming weeks, we do not expect a significant rise in US inflation over the short term. Moreover, since we believe that the fundamental environment remains strong, this sell-off represents a good opportunity to progressively buy risky assets. Since we anticipate market volatility to remain elevated, we believe a more tactical approach to investment will be warranted.

1 Quantitative easing describes unorthodox monetary policy from a central bank in exceptional economic conditions.
2 Volatility Index.
3 Approach to investment portfolio management which focuses on allocation of risk.
4 The action of investors moving their capital away from riskier investments to the safest possible investment vehicles.

Written by Philippe Uzan, Chief Investment Officer, Benjamin Melman, Head of Asset allocation and Sovereign debts at Edmond de Rothschild Asset Management, Richard Beggs, Global Head of Investment Strategy Private Banks Investments & Advisory at Edmond de Rothschild.

Drafting finalized on 6 February 2018

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