Should you be selling stocks? Only if you think growth will disappoint.
That’s the advice coming from J.P. Morgan on Monday, after last week’s sharp correction in equities that began on fears of inflation and rising interest rates, quickly morphed into a surge in volatility, and alternating waves of fear and greed.
With global equities hovering around correction territory, as the MSCI World Index and S&P 500 both started the week down about nine per cent from their January highs, confidence in the market has clearly been damaged by the spike in volatility.
However, typical sources of market contagion are not flashing warning signs, according to J.P. Morgan equity strategist Mislav Matejka. He noted that spreads in the credit and peripheral bond markets have remained reasonable, metal prices haven’t plunged, and real policy rates are still negative – an important factor given that no economic downturn has begun with real rates below two per cent.
Meanwhile, the earnings outlook and analyst revisions remain positive, higher wages usually drive growth, and inflation supports corporate pricing power.
Matejka noted that while growth and earnings are critical to the medium-term outlook for stocks, neither are indicating a reason for concern.
“Only a deterioration in these could drive a sustained selling,” the strategist said. “Most tactical and sentiment indicators have gone from complacency towards fear.”
Matejka also pointed out that in each instance of the VIX spiking more than 50 per cent compared to its past month average in the past 30 years, equities were higher during the next three months, outside of recessions.
If the market were to fall further, the strategist believes this could only happen if cyclicals and financials lead the way on the downside. He also noted that the hedge provided by shorting defensive sectors like real estate and utilities, is a trade that has likely run its course.
“In other words, we don’t see equities falling much further without central banks turning more cautious, and believe that bond yields will not be able to move much higher in that scenario,” Matejka said. “The negative correlation between stock and bond prices is not dead, in our view, it will quickly reestablish itself and ultimately provide a valuation cushion in case of further equity weakness.”
With the MSCI World and S&P 500 having erased their gains of the past two months, the indexes are only a few percentage points above where they were in early September. As a result, most of the tax rally gains have evaporated.
Spiking interest rates and inverse VIX ETFs are taking most of the blame for the recent selloff, yet Ian de Verteuil, head of portfolio strategy at CIBC World Markets, noted that it has not been accompanied by significant concerns in fixed income or foreign exchange markets.
“This is relevant because bond markets are generally better predictors of systemic risks,” de Verteuil said. “We still think equities are the preferred asset class.”
From his perspective, little has changed. North American business fundamentals remain positive, and U.S. economic growth could accelerate
“This risk remains that interest rates move too far, too fast,” the strategist said, adding that he doubts this would bring an end to the bull market, because it would be a reflection of stronger-than-expected economic performance. “However, it could bring the risk of a more extreme correction in equity valuations.”
Pavilion Global Markets noted that the large “short-volatility” trade still exists in many parts of the world and in many asset classes. However, the outright shorting of VIX futures was turned on its head last week, forcing speculators in the VIX to cover their shorts and move to a net long position.
“This probably will help the VIX normalize and equity markets bottom out in the short term, as the crowd is now betting on a continuation of the recent turmoil,” the firm’s strategists wrote in a report.
They noted that implied volatility on Treasury market options hasn’t moved to the same extent, although that may change given the emerging importance of the link between fiscal and monetary policy. That’s largely why Pavilion expects volatility will migrate to interest rates and currency markets.
“Fiscal stimulus in an economy that is at or above potential can lead to faster-than-planned monetary tightening and bring forward the beginning of the next recession,” the strategist said.
“This might be what markets just began to price in last week, with higher long-term yields and lower equity prices. We think equity markets will bottom out and recover soon, but if our diagnosis is correct, interest rate volatility will trend higher this year and the path forward will be a bumpy one.”
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