The events of the last several days offered a taste of the risks I have
written about in past blogs. One risk is that valuations had become so stretched for U.S. stocks that
they were “priced for perfection” – making them more vulnerable to a
pullback at any sign of negative news. Another risk is the potential for
monetary policy disruption as the Federal Reserve (Fed) gradually tries to
normalize. Markets have seemingly been ignoring the potential for more
aggressive Fed tightening if signs of higher inflation appeared. One big
sign – much higher wage growth – was apparent in last week’s U.S. jobs
report, and now markets are scrambling to process the implications.
Keeping the sell-off in perspective
Newspaper headlines suggest that panic has set in. After all, the Dow Jones
Industrial Average fell 4.1% last week, and the 10-year Treasury yield is
at its highest level in nearly four years.2 What’s more,
Deutsche Bank has put out a warning that correlations among asset classes
are very high, creating a major risk of “asset contagion” as one
dislocation or pullback could cause a significant chain reaction.
Before investors start to worry, I think it’s important to keep things in
This sell-off should not come as a surprise,
given that rising rates can alter valuations, causing a re-rating of
stocks. Several market strategists have argued that if the yield on the
10-year Treasury were to rise to 2.75% or higher, it would cause a material
re-rating of the stock market, sending stocks significantly lower. While
some prognostications seemed overly dramatic when they came out – and still
do – it illustrates the concept that higher rates may alter stock
2. We can’t assume rates will go up slowly and gradually.
The reality is that the pace of rate increases may largely be dictated by
economic data, particularly indicators of inflation. And it’s hard for
rates to go up gradually if wage growth isn’t going up gradually. We may
need to expect greater volatility in fixed income going forward.
3. A pullback in stocks is normal and could be healthy.
Stocks have not experienced a significant pullback in several years; in
fact, in the last two years, U.S. stocks, as represented by the S&P 500
Index, have not experienced a drop of 5% or more. That is not typical based
on historical performance, and it suggests, based on a reversion to the
mean argument, that the longer stocks go without any material correction,
the deeper the next correction could be. Therefore, I believe we should
welcome this pullback as a sign that the stock market is normalizing – and
possibly creating buying opportunities along the way.
4. Higher volatility is healthy.
U.S. markets have experienced artificially low levels of volatility for
nearly a decade, since the start of the Fed’s quantitative easing. Such
conditions are a sign of an abnormal market environment, impacted by very
accommodative monetary policy, and have brought with them higher
correlations. I’ve written about
the potential for disruption to lead to higher volatility, which is what we’ve finally started to see
this year. But investors should not fear higher volatility as it typically
brings with it lower correlations and more opportunities to outperform
benchmark indexes – particularly on the downside.
5. Financial conditions are still loosening,
which should soften the impact of rising rates. Corporate bond spreads have
fallen significantly, and high yield spreads have moved slightly lower.
According to the Fed’s most recent Senior Loan Officer Survey, banks are
reducing lending standards on new business loans. The Chicago Fed’s
National Financial Conditions Index suggests that current financial
conditions are looser than we have seen in years. And monetary policy
outside the U.S. remains very accommodative. These factors should provide
an environment that is still supportive of growth in the face of rising
6. The bias for global stocks remains upward.
The global economic environment is accelerating, with the International
Monetary Fund recently upgrading its expectations for global growth. U.S.
growth also appears to be improving (after all, the jobs report that
triggered the jitters was a positive one, showing job gains above
expectations). The Atlanta Fed GDP Now Model recently forecasted 5.4% GDP
growth in the first quarter of 2018; while this seems too high, in my view,
it certainly suggests an improving growth environment. Earnings season has
been positive as well, and earnings are expected to improve this year.
Don’t panic – prepare
In summary, I believe this more volatile and tumultuous market environment
will continue, but stocks may not just experience downward volatility – I
expect upward volatility as well. In addition, we should expect higher
volatility not just in equities, but also in the fixed income market.
Finally, Deutsche Bank’s warning about the possibility of “asset contagion”
should not be ignored. Global markets are tightly interconnected, and it
would not be a surprise to see sell-offs in some assets or regions infect
We also must recognize that the dramatic reaction to signs of inflation in
the U.S. could happen again this year – that’s part of being in a rising
rate environment. It could also happen elsewhere. Consider that the
European Central Bank (ECB) has started to slowly normalize monetary policy
through tapering. The assumption by markets has been that ECB normalization
will be very gradual because inflation is so low – similar to the
assumption that has been made about the Fed. While it seems likely that
European inflation will remain low and that normalization will be very
gradual, that situation could change – just as it appears to be changing in
And so we need to be aware of the risks – but we shouldn’t let those risks
scare us away from markets. Keep in mind these key long-term investing
* Maintain broad diversification. For many investors, this
could include not only stocks and bonds, but also an allocation to
* Don’t be scared and don’t be impulsive. Be disciplined
no matter what the market environment, and keep saving and investing
according to your long-term plan.
1. Source: FactSet Research Systems. Data listed for Jan. 29, 2018, and
Feb. 2, 2018.
2. Source: Bloomberg L.P.
is Global Market Strategist at Invesco.
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Notes and Disclaimer
© 2018 by Fund Library. All rights reserved. Reproduction in whole or in
part by any means without prior written permission is prohibited. This
article first appeared in the
The Chicago Fed’s National Financial Conditions Index (NFCI) provides a
comprehensive weekly update on US financial conditions.
Asset contagion refers to the chain reaction that can happen when a fall in
one asset class leads to a fall in other asset classes.
Diversification does not guarantee a profit or eliminate the risk of loss.
Alternative products typically hold more nontraditional investments and
employ more complex trading strategies, including hedging and leveraging
through derivatives, short selling and opportunistic strategies that change
with market conditions. Investors considering alternatives should be aware
of their unique characteristics and additional risks from the strategies
they use. Like all investments, performance will fluctuate. You can lose
The opinions referenced above are those of Kristina Hooper as of Feb. 5,
2018. These comments should not be construed as recommendations, but as an
illustration of broader themes. Forward-looking statements are not
guarantees of future results. They involve risks, uncertainties and
assumptions; there can be no assurance that actual results will not differ
materially from expectations.
© 2018 Invesco Ltd. All rights reserved. Used with permission.