Equity markets correct in February
Equity markets recorded steep declines in several consecutive trading sessions, before beginning to recover erratically on 9 February. The MSCI AC World index in US dollar terms dropped by 7.6% on the month to 8 February, ending the month down by 4.4% and bringing a 15-month winning streak to an end. The MSCI Emerging Markets index fell by slightly more (4.7% in USD terms) as Asian markets swooned.
The rally in global equity markets from their 8 February low was driven by economic indicators that are still solid on the whole and by strong corporate results releases. There was no radical change in economies or the health of companies compared to late 2017 or January, when equity markets just kept on rallying. The main difference was that inflation moved to the forefront of investor concerns.
The release on 2 February of the US jobs report revealing an acceleration in average hourly wages triggered the sudden fall in equity markets. The sell-off was exacerbated by specific factors: short-volatility exchange-traded notes were forced to suddenly unwind positions, while systematic trading strategies aggravated matters. Against this backdrop, VIX implied volatility, which is calculated on S&P 500 options, spiked to its highest since the summer of 2015 before pulling back to end the month at about 20, up from 13.5 at the end of January.Exhibit 1: Equity and bond volatility indices
The importance of micro and macroeconomic factors
In the US, a robust economy, corroborated by solid economic survey outcomes, triggered a surge in US equity indices after initial declines, but statements by the new Fed chairman and data that was a little less encouraging gave investors reason to worry late in the month. In reaction, the S&P 500 fell by 3.9% in February. The information technology sector ended level thanks to strong earnings. Energy took a hit from falling oil prices (-4.8% by WTI on the month).
Japanese equities suffered from the stronger yen (+3.5% vs. a basket of currencies), with the Nikkei 225 down by 4.5%. Export-intensive sectors were obviously the biggest losers, but strong corporate results led investors back into equity markets in the second half of the month.
The rally in European indices was chaotic, driven by sluggish economic indicators, and, as a result, the markets ended the month down sharply (-4.7% for the EuroSTOXX 50) with all sectors taking a hit; both cyclicals and stocks regarded as more defensive were pushed down as interest rates rose.Exhibit 2: Equity markets as of 28 February 2018 Source: Bloomberg, BNP Paribas Asset Management, as of 28/02/2018
Strong appreciation of the Japanese yen
February featured an appreciation of the Japanese yen (+2.4% vs. the US dollar and +4.3% vs. the euro), which pushed the USD/JPY briefly under 106 on 16 February, a threshold it had not hit since Donald Trump’s election in November 2016. Equity market turmoil early in the month drove this trend due to the yen’s haven status, but the main factor pushing up the yen was the Bank of Japan’s monetary policy.
Since the slight reduction in JGB purchases, for technical reasons, in January, observers have feared a fundamental change in policy. After some hesitation, which strengthened the yen even more, the Japanese authorities ultimately stated that they were ‘very concerned’ by the yen’s appreciation and willing to step in, if necessary. These comments and the confirmation that Governor Haruhiko Kuroda would be reappointed sent the yen back down in the second half of the month, just as it was set to break through key resistance levels. Kuroda noted that price increases remained modest (0.9% in January year-on-year, ex-fresh food, and 0.4% ex-energy) and that it was not yet time to talk about the timing of an exit from ultra-accommodative policy.Exhibit 3: The yen gained 5.6% against the dollar in two months. USD/JPY Source: Bloomberg, BNP Paribas Asset Management, as of 05/03/2018
What to expect after this ‘technical’ correction
We quickly concluded that the correction in the major equity markets in early February was ‘technical’ in nature, due mainly to its severity and the market participants involved in the spike in volatility.
This was borne out by the subsequent rally, but we cannot just dismiss the correction as a non-event, in particular as the 10-year US Treasury yield is now at 50bp above its end-2017 level and at a high since early 2014. Yields have risen as investors priced in the normalisation of the Fed’s monetary policy, which itself is being driven by a strong US economy.
Indeed, a slightly different paradigm to the previous one (characterised by a very low rate of inflation and interest rates) is emerging. To keep this adjustment from triggering equity market stress, central banks – the Fed in particular – will have to reiterate once again that monetary policy shifts will be gradual. They have sought to do so in recent weeks.
But the Fed’s task is not being made any easier by the strength of the US economy, which should get a short-term boost from tax cuts approved in late December and the fiscal stimulus announced in February. The ECB, meanwhile, still has to contend with dormant inflationary pressures and a slight decline in consumer and business confidence in February.
The main risk we see to financial markets is an upturn in inflation expectations (which may or may not be driven by an actual acceleration in inflation), leading to investor fears of a knee-jerk reaction by central banks.
The way equity markets have been trading in recent weeks would seem to suggest that investors continue to focus on solid fundamentals, including sustained global growth and solid corporate results. Available information suggests that this promising environment will remain in place in the coming months. So equities should turn back up, albeit perhaps less smoothly than in 2017, while tracking inflation and inflation expectations.