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Volatility shock – in context

Last year turned out to be a good one for investors and the first time in history that the S&P 500 Index managed to generate a positive return in each calendar month. It was also a year in which volatility was remarkably low. 

It is perhaps unsurprising then, that investors entered in 2018 in an upbeat mood with sentiment looking stretched (US investor bullish vs bearish readings at highest level since 2010) and an overbought equity market (record high in the S&P Relative Strength Index). On the 2 February, non-farm payroll data shook investors from their complacency with the release indicating a sizable increase in average hourly earnings – a trend that heightened expectations surrounding US inflation.  Higher inflation means increased potential for interest rate rises and that isn’t good news for many financial assets.

Rising wages and inflation spooks investors

Annualised US average hourly earnings and US Core Consumer Price Index (%)

Source: Bloomberg

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Volatility traded sharply upwards in the following days and two inverse volatility Exchange Traded Products ended up being liquidated.  The S&P500 fell over 10% over the course of the next few days and subsequent US Core CPI data served to confirm the reality of higher prices. The well above expectations number for CPI was negative for bonds, as expected, but equities rallied hard after an initial short sell off.  The price action perhaps tells us that the normalisation from the volatility shock is more dominant for markets for now than the data. In our view, the February sell-off was a systematic one rather than a correction prompted by a deterioration in economic fundamentals.  In that respect, it was akin to the flash crashes experienced in August 2015 and January 2016.

We think it is too early to call an end to the equity bull market. Despite the rising inflation risk to asset prices, strong underlying growth should underpin earnings. We remain relatively positive on the prospects for equity markets and geographically we continue to like the emerging markets.  Valuations look reasonable relative to both history and their more developed counterparts.  We are also positive on Europe where we expect growth to better expectations with domestic demand increasing and the region (especially Germany) geared into emerging market strength through its exporters.  Prospects for the UK look more subdued however - a function of Brexit associated uncertainty and sterling appearing vulnerable.  The likelihood of higher inflation means we have become more cautious on US Treasuries and investment grade credit.

BMO Multi-Asset Team

This update may contain forward-looking statements which can be identified by the use of terminology such as ‘may’, ’should’, ‘expect’, ‘anticipate’, ‘outlook’, ‘project’, ‘estimate’, ‘intend’, ‘continue’ or ‘believe’. These do not constitute investment advice or recommendations to buy or sell investments and you should not place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties.