The inflation figure that was published three days before new Fed Chair Jerome Powell took office was seen as a bit high, and lit the fuse on 2 February: the S&P500 fell -10% from its peak on 26 January, dragging the other markets down with it.
In fact, this movement was amplified by the unwinding of speculative positions, specifically, downward on the VIX. Six comments are called for:
- There are similarities with 1987:the economic growth recovered in 1986 and in 2016 owing to an oil countershock. There is no imminent risk of recession. The market downturn is amplified by technical factors.
- There are also differences:while Janet Yellen opposed the equity markets' high prices, the Fed can be satisfied with this correction, especially since the fixed-income markets have converged with the dots. In 1987, as usual, equities waited for the Fed to lower rates before getting their confidence back and heading up again. If necessary, the Fed may have to do something different this time to reassure, probably more in terms of communication.
- The US market is still expensive.The PER calculated on the profits of the past 12 months went from a high of 22x to a low of 20.6x before rebounding to 20.9x. This is still much higher than theRule of 20suggests, i.e. that a PER of more than 20 minus inflation (i.e. 18x) is expensive.
- Investors will have to adapt to higher volatility.The upswing by the VIX is technical, yes, but it still signals a change in the trend. Traditionally, volatility follows two years behind the Fed's rate increases; yet the Fed first raised its rates in December 2015. A market rebound should be the chance for investors to adapt their portfolio to this new regime, so it will take several weeks for equities to start trending upward again.
- For now, this shock has not caused any major rotation.Credit spreads have not widen, and cyclicals continue to outperform defensives; meanwhile, tech stocks are not underperforming. However, we should expect that higher volatility accompanying lower liquidity will gradually promote a run on quality - in other words, the equities of the least leveraged companies and the lowest-risk credit, which is already happening in the US.
- The equities-bonds correlation is unstable, but has not yet structurally reversed.The equity shock took place at the same time as a rate increase. This type of relationship has been rare since 2008. Indeed, when there is a deflationary risk, the rate increase, which means a reduction in this risk, is logically favourable. And vice-versa. Once the change in the context of volatility is integrated into portfolios, then, we can imagine that as long as growth is profitable, equities could rise, even with long-term rates going up. Whereas the prospect of a recession, which is negative for equities, would eventually be accompanied by a decline in long-term rates. Obviously, there is a limit to this reasoning, if long-term rates spike or climb above 3.5%.