It turns out there actually is no free lunch on Wall Street. Traders who thought that a bet on continued low volatility was a sure thing have found out otherwise over the past two trading sessions. Following on the heels of Friday’s 2.1% drop in the S&P 500, the index dipped another 4.1% on Monday, marking the first time since summer 2016 that the market has fallen by more than 5%. This ends a stretch of 395 trading days without a correction, eclipsing the old record from the mid-1990s by exactly one day.
To put this decline into context, consider the nearby three-year graph of the S&P 500. As of Monday’s close, the index is now back to where it was in mid-December 2017, an observation that underscores how far the market has rallied. After going nowhere in 2015 and starting 2016 on a sharp downswing, the market has rallied almost without pause for several years. We were long overdue for a correction.
The speed of the decline in the last hour of trading on Monday was reminiscent of the flash crash of May 6, 2010, when a combination of algorithms and high frequency trading drove the market down sharply in the last 90 minutes of trading. Although the dust is far from settled on the current situation, we suspect that unwinding a crowded trade in low volatility bets explains Monday’s flash sell-off. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV), a popular tool for active traders making volatility bets, was off 14% during trading hours, before dropping an additional 84% in the aftermarket. The ProShares Short VIX Short-Term Futures ETF (SVXY), another popular tool for volatility traders, dropped 31% during trading and shed another 80% after hours. Both funds consist entirely of short positions in the February and March 2018 VIX futures. Unwinding those short positions became very expensive over the course of the day, as the VIX more than doubled to end the session at 37. One smaller inverse VIX fund has already announced a liquidation, and more are likely to follow.
This may explain how the decline accelerated on Monday, but not why the decline started in the first place. For that, we look to last Friday’s monthly jobs report. The economy added 200,000 net jobs in January, in line with the average for the past year, which resulted in an unchanged unemployment rate of 4.1%. Nothing to see here, move along. The surprise lay in the wage figures, which revealed that average hourly earnings growth accelerated for the third consecutive month to an annual pace of 2.9%. This is not an alarming figure in itself, but it does mark the fastest wage growth in nine years and heightens concern that the Federal Reserve may be underestimating the threat of inflation.
In our top 10 list of things to watch in 2018, wages took the honor of first position, precisely because of the potential inflationary pressures that might arise from excess wage growth. Other measures confirm that employment costs are indeed rising: The producer price index is rising faster than consumer inflation, and the employment cost index (which includes non-wage benefits) is rising at its fastest pace since 2008.
Financial markets have begun to price in the risk of higher inflation. The 10-year Treasury yield rose from 2.4% to 2.8% over the course of January, and the 30-year yield topped 3.0%, although yields were down Monday (and bond prices up) in a classic flight to safety. Futures markets were assigning a 99% probability to a March Fed rate hike as recently as January 31, although this probability has dropped a bit to 77% over the past few days.
Conventional wisdom holds that higher interest rates are bad for equity markets. The rationale is straightforward: The worth of any security is simply the net value of its future cash flows, discounted back to the present at an appropriate rate. The higher the discount rate (i.e., interest rate), the lower the present value, and vice versa, all else being equal.
So far, so good, but all else isn’t equal. This simplistic model ignores the question of why interest rates are rising. To the degree that rising interest rates reflect growing confidence in the pace of economic activity, so, too, should corporate earnings growth be more robust, thereby raising the cash flows that are discounted back to arrive at the fair value of the security. The tradeoff between higher interest rates and the pace of earnings growth is the fundamental question for equity markets in 2018. As long as corporate earnings continue to grow, the equity market should be able to withstand higher interest rates.
And it appears that earnings remain healthy. With a little over half the S&P 500 membership reporting (as of February 5), corporate profits for the fourth quarter of 2017 are rising at an annual pace of 23.8%, ahead of consensus expectations. Importantly, this is before the effect of tax reform, which should provide an additional tailwind to earnings in 2018.
There is no question that this bull market is aging. And there is no question that the market was long overdue for a correction and a return to more normal levels of daily volatility. Some investors on the wrong side of that trade are paying a steep price this week. We nevertheless believe that the fundamentals as reflected in the economy and corporate earnings remain supportive, while recognizing that the intersection of wages, inflation, monetary policy, and corporate earnings will likely introduce more volatility into financial markets in 2018.
This serves as a timely reminder that price disruption, while unpleasant, is not the enemy of the disciplined investor. Indeed, volatility is precisely what enables the patient investor to take advantage of the difference between price and value.
The views expressed are as of February 6, 2018, and are a general guide to the views of Brown Brothers Harriman (“BBH”). The opinions expressed are a reflection of BBH’s best judgment at the time, and any obligation to update or alter our views as a result of new information, future events or otherwise is disclaimed. Nothing contained herein is intended as a recommendation to buy or sell any security, or to invest in any particular country, sector or asset class. Past performance does not guarantee future results.
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PB-01989-2018-02-06 Expires 2/28/2020