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What should we make of the pullback in equities?

What should we make of the pullback in equities?

Guest Post - Monday, February 12, 2018

1. What should we make of the pullback in equities?

As we discussed in our special note last week, pullbacks are a normal component in the cycle of any market, with a few steps forward-one-step back pattern being the tendency of stock investments for the past several centuries. We have largely forgotten this with a stretch of good news and very low volatility compared to history, but -5% corrections have routinely occurred several times a year, and -10% corrections an annual occurrence on average. There are several important components here, some of which are technical and others fundamental.

One is that positive tax reform sentiment led to an above-trend, nearly parabolic, rise in equity market pricing in 2018. Such a pace in one direction is clearly not sustainable; the key issue becomes how long the good times could last before 'normalizing'. More extreme cases of straight-up price momentum are witnessed with financial bubbles, where the severity of the drop is related to some degree by the magnitude of the prior gains. On a long-term chart, this last week will barely register as a blip, as we have ended up back to where we were in November.

The fundamental backdrop is important when considering future prospects for equities, and whether a routine correction could morph into a more dramatic event. Historically, deeper corrections that lead to 'bear markets' (usually defined as losses of -20% or more from a prior peak) are the result of one or more specific fears: a recession, the Fed hiking interest rates too much/too fast, high inflation (actual or feared), or other shocks such as war or a spike in energy prices. Why these matter for stocks is the impact on earnings, as growth in earnings has been one of the two key drivers in long-term equity returns (the other being dividends). Right now, earnings are continuing to improve, with growth rates expected to be in the +10% range for this year and perhaps next. Corporate tax reform has boosted prior projections in addition to a general pickup in global economic growth.

All-in-all, according to fundamental metrics, the environment for risk assets remains positive, with indicators such as employment, manufacturing and credit in generally good shape. Of course, this won't last forever, as the room for accelerating improvement has likely shrunk from where it was a few years ago when the business cycle was less mature than it is now.

2. What should we make of the move higher in interest rates?

The financial crisis nearly a decade ago prompted the FOMC to ease monetary policy to an extreme level—moving short-term interest rates to near zero. While debate continues about the low levels and length of time this policy was in place, it did coincide with the subsequent decade's strong economic and asset market recovery. While long-term trends are also only visible in hindsight, it's quite likely those near-zero rates represented the low for this cycle. The pace of policy normalization has been closely watched since, and the recent pullback for both stocks and bonds is in no small part due to expectations of the Fed continuing to raise short-term rates at a consistent clip. The ongoing question is: how fast will this occur?

  • Income-seeking investors, such as retirees living off of bond and cash interest, have lamented the low rate environment, especially as these translate to zero or negative after-inflation 'real' rates. Rising rates mean the obvious—that money markets and cash equivalents are now paying increasingly competitive returns. For example, a near-0% rate for spare cash has been replaced by money market rates of 1% or more—comparable to online savings accounts again and shrinking the gap with some bond instruments.
  • Regulatory change for money markets has shifted the market environment dramatically over the last several years with the bulk of assets moving from prime (commercial) paper over to U.S. government paper. However, now that commercial paper is subject to lower institutional demand, prime fund rates have moved up in relative terms compared to treasury funds, creating attractive short-term investment opportunities.
  • While prices of outstanding bonds can suffer when rates rise (especially those with long durations), newly issued bonds now offer more attractive yields.
  • Certain sectors can react decently to higher rates, such as banks and insurance companies, based on the resulting 'spread' between lending and borrowing.
  • Perhaps most importantly, if done in a gradual way, rising rates are indicative of a positive economic environment. In the most favorable scenario, a moderate pace of interest rate increases can act as a 'tap on the brakes' to keep economic growth in check. Overheating economies and often-accompanying asset bubbles can be far more destabilizing, creating more dramatic imbalances and lead to more distress down the road
  • Can coincide with higher inflation (which is often a catalyst for the Fed moving rates higher in the first place, being a key part of their mandate).
  • Increases borrowing costs for businesses and consumers. If rates get too high, it can be more difficult and costly to refinance or take on new debt. This can put a damper on areas like corporate capex spending, homebuying activity and other investment.
  • As a governmental policy issue, it also raises borrowing costs for the U.S. treasury, which is also grappling with a roll-off of their bond portfolio built up over the period of quantitative easing and, now, the addition of higher fiscal deficits (which could reach $1 tril./year). Deficits raise the supply of bonds and increase overall debt/GDP levels, which is not a plus for a country's credit standing.
  • Affects discount rates for risk assets, lowering their fair values
  • Can negatively affect sectors that are more heavily leveraged, as well as some higher-dividend stocks, as these now have to compete against higher-yielding bonds.
  • U.S. dollar. Generally, high inflation is a negative for a currency, causing it to weaken relative to others. On the other hand, a strong economy and gradual rate increases could propel a currency higher. All of this depends on expectations but also the relative attractiveness of other currencies, which affects foreign flows.

Read our Weekly Review for February 12, 2018.

Read the previous Question of the Week for December 26, 2017

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