Time for a correction?

By David Morrison  |  31/01/2018 16:22

This article considers whether this week's equity sell-off is simply month-end profit-taking or the start of a more significant correction.

Pull-back overdue

All the major US stock indices opened sharply higher this afternoon following a hefty sell-off over the previous two sessions. Of course, commentators have been saying for a while now that a pull-back is well overdue, particularly given the rally since the beginning of the New Year. This week’s retracement has been more substantial than anything we’ve experienced since the summer of 2016 in the aftermath of the UK’s surprise vote to leave the European Union.

State of the Union

Last night’s State of the Union address from President Trump helped to lift US stock index futures in early trade. Mr Trump was widely credited with delivering an upbeat and inclusive speech which tied in with a similarly statesman-like performance in Davos last week. Once again, the president promised to put “America first” but there was relief that he pulled back from any aggressive protectionist rhetoric.

Strong jobs number

There was also the release of a strong ADP Employment number ahead of today’s open. This helped to lift sentiment and raised expectations for a better-than-expected Non-Farm Payroll number on Friday. A further improvement in the jobs data along with a pick-up in Average Hourly Earnings will help to lift confidence and boost inflation expectations.

Yellen’s last meeting as Chair

Later this evening sees the culmination of a two-day meeting of the Federal Reserve. This will be Janet Yellen’s last as Chair as she now hands over to Jerome Powell. This transition is expected to be smooth and uneventful as Mr Powell is understood to hold similar views on monetary policy to Janet Yellen. Additionally, according to the CME’s FedWatch Tool there is effectively no chance of a change in the fed funds rate after tonight’s meeting, although there’s a 72% likelihood of a 25 basis point rate hike in March.

Bond yields trigger sell-off

But back to the equity sell-off at the beginning of the week. The trigger for the move was the pick-up in global bond yields as there’s a growing expectation of higher interest rates, not just in the US but across the Euro zone and Japan as well. The key 10-year US Treasury yield rose above 2.73% to hit its highest level since April 2014. German bund yields have also risen sharply over the past six weeks, as have those for Japanese Government bonds. Overall, the reason for this is positive as investors see further evidence of synchronised global economic growth and a pick-up in inflation after years of deflationary fears (which makes debt repayment so much more problematic).

Tighter monetary policy

But the flipside to a pick-up in growth and inflation is that developed-market central banks are all now looking to tighten monetary policy at the same time. Given that their zero/negative interest rate policies and quantitative easing programmes have been responsible for boosting asset prices over the last nine years, the withdrawal of such stimulus is likely to have the reverse effect. Fortunately, it would appear that rate hikes and the wind-down of central bank balance sheets is happening at a glacial pace. Stock market bulls have faith that growth in corporate revenues and earnings will easily counter the effects of increased borrowing costs. That will be the case for many companies. However, it won’t take a big move in interest rates for over-indebted businesses to struggle to refinance or repay existing debt.

Infrastructure spending

At the moment, investors are still riding the wave of euphoria that followed Trump’s tax reform package passing through Congress last month. This was the fulfilment of a major campaign promise along with regulatory reform which is also taking place. These fiscal measures have helped offset the negative market effects of monetary tightening, at least in investors’ minds. The third promise was on infrastructure spending – something that the president spoke about in last night’s State of the Union address. In fact, Mr Trump’s call for $1.5 trillion worth of spending to upgrade US roads, rail network and airports was a major catalyst behind today’s early bounce-back in US stock indices. However, a number of analysts have already come out to insist that there isn’t a snowball’s chance in hell of anything being passed by Congress ahead of this year’s mid-term elections. That may be so, although it’s worth remembering that’s what everyone was saying about tax reform just a fortnight before it passed through both Houses.  

Correction or profit-taking?

The equity market is well overdue a pull-back with a number of respected industry professionals expecting a significant correction (typically understood to be a move of 10% or more) at some stage in 2018. Yet this week’s move could be nothing more than a bout of month-end profit-taking, triggered by a temporary increase in yields. If so, then today’s early bounce-back demonstrates yet again how anxious investors and traders are to have exposure to this market as they rush to buy even the shallowest of dips. But could this time be different? After all, the rally since the beginning of this year has been explosive with it being repeatedly referred to as a classic “melt-up” - which typically precedes a significant sell-off. Not only that, but as today’s session progressed the US majors pulled back from their best levels as the yield on the US 10-year suddenly broke back above 2.73%.

This week is crucial

So this week could prove to be key in deciding the direction of travel over the next month or so. We may see the US majors break higher and go on to make fresh records. If so, then all that means is that a more meaningful correction has been postponed. But if prices don’t bounce back sharply this week then it could signal the start of a more protracted sell-off. If this happens then at least we’ll have some intermediate highs to work with and this can help with technical analysis going forward. 

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