Volatility shakes up markets. Is the worst yet to come?

On the latest edition of Market Week in Review, Consulting Director Todd LaFountaine and Senior Investment Strategist Paul Eitelman discussed the catalyst and potential future implications surrounding this week’s global market sell-off.

What led to the market sell-off?

The starting point for the market shake-up was last Friday, Eitelman said, when January’s employment report showed stronger-than-expected wage growth. The 2.9% pick-up in wage gains—the greatest increase since 2009—came as a surprise to many investors, Eitelman said, and triggered a sell-off in bonds. To wit, 10-year U.S. Treasury notes have been trading at 2.8% for the past week—the highest level in four years, he said. “These high bond yields quickly became a meaningful headwind for the equity market,” Eitelman explained.

The sell-off was further accentuated by two other factors, in Eitelman’s view: Sentiment and trading strategies. “Ahead of Monday’s plunge, investor sentiment had been getting very optimistic—bordering on euphoric,” he stated—“and this made markets vulnerable to any bad news.” Secondly, the strong performance of markets in 2017 had led to a lot of money and momentum trading strategies, Eitelman said, with many investors betting on a low-volatility environment persisting. “When that turned—when indicators like the CBOE Volatility Index® (VIX) spiked—a lot of individuals were forced to sell at the same time, and that further exacerbated things,” he said.

Are we headed for a recession?

The viewpoint of Eitelman and the team of Russell Investments strategists is that this week’s downturn likely represents a breather for markets, rather than the start of something worse. “A much bigger sell-off—a drop of 20% or more into a bear market—is almost always caused by an economic recession,“ he emphasized. This, however, does not appear to be in the works, in Eitelman’s opinion, as growth data and cyclical fundamentals remain strong and robust. As evidence, he pointed to the J.P.Morgan Global Manufacturing PMI™ index, which came close to an 82-month high this past January.

In addition, said Eitelman, most companies have generally been beating expectations during fourth-quarter earnings season. “In the U.S., earnings growth has hovered around 13%— which is really good,” he stated, adding that the numbers have been even more impressive in Europe. “Ultimately, for us to be worried about a much broader and deeper sell-off, we’d be looking at a growth scare to creep in—and we’re just not seeing that now,” he concluded.

January’s CPI number: Could it spark another sell-off in the short term?

So, how can we expect markets to behave in the short term? Next week could be a key indicator, Eitelman said, because that’s when the U.S. Bureau of Labor Statistics will release the Consumer Price Index (CPI) number for January. “Given that one of the triggers for the sell-off was an inflationary scare, Wednesday’s inflation number will be telling,” he said. In his view, the CPI number should come in close to consensus, with maybe a little upside risk. However, if it’s stronger than expected, Eitelman believes that could be a catalyst for another sell-off.

In addition, Eitelman noted that this week’s downturn was primarily concentrated in equity markets. “We haven’t really seen a significant widening in credit spreads or the market repricing default risk for businesses,” he pointed out—“which means the borrowing costs for companies hasn’t moved up.” Ultimately, in Eitelman’s viewpoint, this week’s downturn was most likely a healthy correction for markets—and nothing more.

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