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3 Reasons for the Market Sell-Off

February 2018
By Nanette Abuhoff Jacobson

The market is recalibrating to a new environment.

 


 

The context of the recent sharp sell-off is important to consider. There have been big changes in recent weeks. We’ve had a 0.75% percentage point increase in US government bond yields, the potential of rising inflation, and an equity market that had the longest monthly winning streak (10 months) since the 11 months ending January 1959.1

A correction should not be surprising.

 

3 elements fueling this sell-off

I think there are three elements to this sell-off: fundamentals, central bank policy, and technicals.

Fundamentals—Markets were fine with the notion of nominal growth rising, so long as that was mostly real growth.2 Now, with average hourly earnings rising a surprise 2.9%, commodity prices rising, and labor shortages in the US, Europe, Japan, and China, inflation has returned as a concern.

Central bank policy—If inflation is increasing from 1-2% to 2-3% in the US, it could mean a faster pace of Federal Reserve tightening. A few weeks ago, the market wasn’t even priced for two interest rate hikes in 2018, and now there’s the possibility of four. 

Technicals—In a recent Wellington Management morning meeting, we discussed the types of funds that could be getting hurt, precipitating forced sales and exacerbating the moves in equities, yields, and volatility.

Here are a few:

  • Short-volatility funds were all the rage last year, and they made a lot of money. But these levered funds could suffer massive drawdowns with a rise in volatility. 
  • Target-volatility funds often have to sell equities when volatility exceeds 10%. With higher volatility, funds need to sell even more. 
  • Risk-parity funds have levered long-bond exposure. The fall in bond prices is amplified and, worse still, equities are down, too. Given the “gappy” moves in the market, I think we have to attribute a large technical element to recent moves.

 

Recalibrating is healthy

These factors do not, however, change my view of the solid global fundamentals in place that should ultimately support risk markets. The market is recalibrating to a new environment with higher nominal yields and higher inflation. That’s a big deal, and it could take some time to level out. We will also have to monitor technicals to evaluate whether losses could become more systemic. I remain confident that this is a healthy correction and not something more pernicious.

MFGS_020718_1

Data Source: Morningstar. S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. Past performance is not aguarantee of future results. Investors can't directly invest in an index. 

MFGS_020718_2

Data Source: Yahoo Finance. “VIX,” commonly referred to as the “Fear Index,” is the ticker symbol for the Chicago Board Options Exchange (Cboe) Volatility Index and measures the market’s expectation of 30-day volatility. Past performance is not a guarantee of future results. Investors can't directly invest in an index. 

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Data Source: St. Louis Federal Reserve and Factset. Past performance is not a guarantee of future results. 

Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.

1 “Risk Roars Back,” Barron’s, 2/3/18

2 Real values are adjusted for inflation. Nominal values are not. 

All investments are subject to risk, including the possible loss of principal. Indices are unmanaged and not available for direct investment. Fixed income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened because interest rates are at, or near, historical lows. 

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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