What’s behind yesterday’s stock market sell-off?
One day removed from Monday’s big losses in the stock market, recent equity weakness still looks like a valuation-based market correction rather than the beginning of a bear market.
Because first and foremost, bear markets are driven by fear—almost always the fear that economic growth is about to end. If that fear exists, it drives all markets, not just equities. While the recent movements in the stock market may look like fear, the behaviours of other asset classes are telling us that equity markets are primarily concerned about the valuation of equities—perhaps even a little worried about what we consider expensive U.S. equities—but they are not generally fearful.
In short, we feel this is a healthy market correction of stock valuations, rather than a classic fear trade, because of what we are not seeing.
In a typical fear-driven market sell-off propelled by fundamental concerns over future economic activity, you typically see the following four market behaviours:
- The riskiest assets in terms of the capital structure—i.e., equities—sell off dramatically as the market becomes concerned that future earnings are in jeopardy. Checkmark: Yesterday’s market loss.
- Other risk assets—like high-yield bonds—also sell off as the market becomes concerned about the future credit worthiness of debtors, and credit spreads widen dramatically. No checkmark.
- Recession fears cause a flight to quality and U.S. Treasury instruments (sovereign bonds) rally, causing yields to fall substantively. No checkmark.
- The price of gold increases substantially based on fear of financial assets. No checkmark.
So far, the current market sell-off is one for four in our recession-driven sell-off checklist.
So, if the equity market is selling off over concern about valuations rather than fear of recession, what was the match that lit this fire? Our answer: inflation concerns.
Strong synchronised global growth over the last year—and particularly, in the last few months—has driven the market to expect higher future inflation. As proof, note the 50-basis-point rise in the U.S. 10-year Treasury note from the beginning of December until last Friday, Feb. 2, when it topped out at 2.84%.1 On the backs of these inflation fears, equity market performance was already not as strong for most of last week. And then came the real kicker: Friday’s U.S. jobs report. The numbers, released by the Bureau of Labor Statistics, showed that December wage inflation came in at 2.9%—the highest rate since 2009—likely confirming higher inflation worries in the eyes of the market.
Why do higher inflation expectations often lead to short-term stock market weakness? For two basic reasons: First, higher inflation expectations, as a rule, increase the yield on bonds. Higher yields typically make bonds more attractive than equities, which pushes equity prices lower. Second, higher inflation causes future earnings to be less attractive. This is because the net present value of future earnings is less valuable when future inflation is expected to be higher.
As an example, receiving $10 in earnings three years from now—when we expect 3% inflation over those three years—is not as valuable to me as when I expect 1% inflation over those three years. Why? Because I can buy less stuff with that $10 in three years.
Ultimately, in our view, it is precisely this inflation dynamic that is causing the ongoing market correction, rather than recessionary fears. And we practice what we preach. Case-in-point: At Russell Investments, our team of strategists was at policy weights in our equity allocations ahead of this sell-off—but we braced for the sell-off by underweighting U.S. equities, which we viewed as the equity market sector most vulnerable to this type of correction. Today, we are still at policy weights in equities and still underweight U.S. equities—because although they’re cheaper now than a week ago, they’re still very expensive based on historical measures.
The take-home message? We feel this is not a time to panic, nor is it a time to get greedy. In other words, keep calm and carry on.
1 Source: fred.stlouisfed.org