Loud Noises and the Return of Volatility

Market Updates

Loud Noises and the Return of Volatility

Nicholas Lacy, CFA, Chief Portfolio Strategist, reflects on how markets adjusted to increased uncertainty in the first quarter.

March 29, 2018

U.S. equity markets soared to record highs at the end of January only to reverse course into a freefall over the next several days. The remainder of the first quarter was choppy as investors grappled with increased uncertainty following an extended period of steady gains against a quiet market backdrop.

The sudden increase in volatility led to the largest one-day decline in the history of the stock market on an absolute point basis with the S&P 500 dropping over 115 points on Monday, February 5. However, the move only represented a 4.16% decline on a relative basis. It was strikingly similar to the crash on October 19, 1987 (also known as Black Monday), as leveraged products and computerized trading programs, not individual investors, were triggered to sell off equities.

In fact, individual investors remained relatively calm throughout the quarter as lingering memories of the 2008 financial crisis and subsequent recovery had them thinking twice about hastily exiting the market. Backed by a healthy global economy and increasing revenues and earnings expectations for U.S. companies, the noise of the headlines seemed to be just that. Noise.

Not So Defensive Equity

While the market correction may have caught some off guard, even more surprising was the underperformance of defensive equities that have historically held up in down markets. Various sectors including Real Estate Investment Trusts (REITs), Energy, and Telecom typically pay higher dividends, which should have cushioned prices relative to the overall market. However, downward pressure on bond prices escalated losses for these stocks due to their natural sensitivity to interest rates.

What Diversification?

While one would expect bonds to rally during a market downturn, investment-grade bond prices slowly declined throughout the quarter as interest rate pressures prevailed. We should not be surprised that bond prices are falling as interest rates have been on the rise since the end of 2015, and we have yet to see longer-term yields rise much. This can be problematic as the Federal Reserve (Fed) is expected to continue raising short-term rates this year, potentially causing further flattening of the yield curve.

A flattening yield curve has traditionally been viewed as an indicator of negative market sentiment toward long-term growth of the economy. With long-term rates inching up and the yield on the 10-year Treasury approaching the 3% mark, this issue could very well be a moot point. So, what is the market telling investors?

Confidence is Key

Looking ahead, the market may have more confidence in both economic growth and inflation expectations, and global equity markets appear poised for another above-average year in market returns. A steeper yield curve (the difference in the 2-year and 10-year Treasury rates) has historically been a positive signal for equities and may help boost cor­porate earnings, especially within the Financials sector.

Fixed Income: Due for Its Own Correction?

U.S. investment-grade bonds have rarely lost money in the past 30 years. The most sig­nificant loss was in 1994, when the Fed unexpectedly increased the fed funds rate by 50 to 75 basis points each time. Lack of transparency in the magnitude and timing of these increases led to a negative reaction from the markets.

On the other hand, post-financial crisis policy has been openly and clearly communicated by the Fed, minimizing the surprise element of Fed actions. While it is likely that bond prices will finish the year lower than they started, fixed income remains a foundational element of a diversified port­folio and should continue to serve as a ballast amidst turbulent equity markets.

 

Read the full April 2018 Investment Strategy Quarterly
Read the full April 2018 Investment Strategy Quarterly

 

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc. and are subject to change. Past performance may not be indicative of future results. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Diversification and asset allocation do not ensure a profit or protect against a loss. Companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. REITs involve risks such as refinancing, economic conditions in the real estate industry, changes in property values and dependency on real estate management. Bond investments are subject to investment risks, including the possible loss of the principal amount invested. The yield curve is a graphic depiction of the relationship between the yield on bonds of the same credit quality but different maturities. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index.



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