A sudden selloff on global markets brought a dramatic spike in volatility, as investors looked to interest rate policy.
Much has been said in the past couple of years about the feasibility of having your cake and eating it. On markets, however, investors in recent years have become inured to the miraculous – until last week.
When the global economy is growing and unemployment is low, it is usually expected that interest rates will be set on an upward path that will – ultimately – arrest stock price growth. Yet for some time, even short-term investors have enjoyed a sweet spot of fortuitous circumstances: titanic quantities of money ($15 trillion) pumped into the market by central banks; negligible (but sufficient) inflation; and buoyant corporate earnings and global growth. As a result, money has been cheap to borrow, but stocks have offered strong – sometimes sensational – returns. In 2017, US inflation averaged just over 2%, the Fed funds rate only rose as far as 1.5%, volatility remained at historic lows – and the S&P 500 surged by 19%.
Last week, however, some investors were saying the miracle was finally over. The fireworks on markets had begun the previous Friday, but on Monday the S&P 500 underwent its biggest one-day dip since August 2011. The following day, the world followed suit, as leading indices in Europe and Asia saw rapid drops. Talk of a possible correction has been widespread in recent months, but the timing took investors by surprise. So, too, did its rapidity. The S&P 500 bucked and reared over the course of the week, as volatility persisted. The index ended the week down 4.4%, while the FTSE 100 fell by 4.7%, the Eurofirst 300 by 5.1% and the Nikkei 225 by 6.7%. While some investors were knocked off course by the sudden resurgence of volatility, more experienced stock-pickers know only too well that short-term volatility is far from abnormal on markets.
Behind the falls lay a rise in the yield on the 10-year US Treasury. It had risen rapidly after the release of payroll data that showed wage growth finally beginning to tick up meaningfully in the US, the same day that Janet Yellen ended her tenure as Chair of the Federal Reserve. The rise in yields reflects expectations that interest rates will rise more quickly than previously anticipated. If they do so, the relative appeal of equities might begin to fade for short-term investors, given the higher bond yields on offer.
The clearest gauge of last week’s freneticism is the VIX, which measures volatility on the S&P 500. Over the long term, the VIX has averaged 20 points – a score below 20 means volatility is subdued. In recent years, the VIX has generally sat at historic lows, highlighting the extraordinary calm that has characterised markets. In July last year, it struck a record low of 8.84 points. Last week, however, it struck an intraday peak of 50 before settling back into the low to mid 30s.
It is not entirely clear why it surged quite so far, but a couple of technical reasons have been proffered. For one, some investors in recent years have placed large bets on low volatility – last week those bets unwound in dramatic fashion. For another, it may have been exacerbated by algorithms and machines. JPMorgan Chase said last week that just 10% of trading is regular stock-picking, while the remainder is based on computer formulas. Some passive funds, for example, will sell off automatically when the market starts falling, adding momentum to an emerging pattern. Another argument is that a significant number of stocks were overvalued and, thus, all a correction really needed was a meaningful trigger. In such contexts, good active management comes into its own.
“Obviously buying a passive fund, you’re basically buying access to exposure to each of the stocks in the market,” said Nick Purves of RWC Partners, “and for obvious reasons, it’s often the most expensive stocks which have the biggest weighting in the market. So right now, when markets are high, you probably do need to be more selective in what you hold.”