Investors are seeing red again on Monday, and while much of the early damage appears to be dissipating, the global equity selloff that began last week is now at the forefront of the market’s mind.
While the lengthy bull market in stocks, coupled with high valuations in many sectors, gives investors plenty of reason to pare back their exposure, it’s the bond market that is taking much of the blame.
Friday’s stronger-than-expected U.S. wage growth data exacerbated concerns that had already emerged due to the spike higher in global bond yields.
“What makes this equity selloff different than most is that there has been no flight to safety to bonds,” said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates. “This means that this is not ‘event’ driven and as such, could last a bit longer since ‘events’ like Brexit or debt ceiling issues… ultimately are dealt with. This is about the Fed having to step up the game of liquidity-drainage, pure and simple.”
Accelerating wages are a key risk for equities this year, as they could squeeze profit margins and also push the Federal Reserve to be more aggressive in raising interest rates, according to Ben Laidler, global equity strategist at HSBC.
“…The inflationary backdrop remains relatively benign, and we forecast that U.S. treasury yields will peak around current levels, equities could see further downside in the near term,” Laidler said.
The bank’s investor sentiment indicator has breached the level that has historically signalled a sell, implying that a correction may be overdue.
It’s been one of the most volatile starts to a year in two decades, as investors grow more concerned that the movement of bonds could disrupt markets around the world.
“Bond bear markets are rare, but so are declines in equities and credit because of them,” said John Normand, head of cross-asset fundamental strategy at J.P. Morgan.
Stocks have only rallied as much as they did in January one time (2001) in the past 20 years, and the same goes for the selloff in bonds (2009).
U.S. 2-year yields around 2.17 per cent are close to a 10-year high, and 10-year treasury yields are at a four-year high of about 2.85 per cent.
While many are worried about the move higher in yields triggering a reversal in the outperformance of asset classes like equities, credit and emerging markets, Normand thinks related assumptions are unwarranted. That’s because the current environment requires some important context.
Indeed, a 10-year yield approaching three per cent is alarming given that its the highest level since 2014. But rates look much more normal – and perhaps too low – considering that oil prices are at a three-year high, GDP growth is at the strong level in eight years, and U.S. unemployment is at an almost 20-year low.
“Investors should worry much more about two types of bond market moves – high-volatility ones due to a dramatic rethink on Fed policy, or ones driven more by inflation surprises than stronger activity data,” Normand said. “The taper tantrum in 2013 was an example of the first, and Treasury sell-offs in 2005 and 2006 examples of the second.”
If there are repeated upside surprises for inflation data, the strategist believes the second sort of bond market moves could drive stocks lower and volatility higher. That’s because it would reverse the typical negative correlation between bond and stock prices that risk allocation investments are based on.
Gluskin Sheff’s Rosenberg noted that Friday’s equity market weakness wasn’t only marked by sharp price declines, but also the vigorous selling among institutional investors. He also pointed out that Nasdaq volumes climbed for the fifth of the past six days, and the selloff was so broad that more than nine stocks declined for every advancer.
“Heavy institutional selling from euphoric highs as we have seen tends to build momentum,” Rosenberg said. “This is a time for extra caution.”
He believes stocks could fall another six to seven per cent, which would make this the first meaningful correction since early 2016.
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