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What now?

By David Morrison  |  08/02/2018 15:54
This article looks at the importance of stepping back and waiting for the smoke to clear after dramatic market moves

Biggest sell-off in two years

As everyone who follows financial markets knows well, the current sell-off in global equities has been a long time coming. Prior to the price action over the last ten days, the major US indices had rallied almost without interruption since the Brexit vote in June 2016. Even the knee-jerk sell-off in response to Donald Trump’s surprise victory in the November 2016 Presidential Election could be measured in minutes rather than hours. In fact, the last time there had been any kind of substantial correction in stock indices was two years ago, triggered by the second clumsy Chinese currency devaluation in under six months.

No “flash crash”

While well overdue, the sell-off in US stock indices has still left its mark. After falling nearly 666 points last Friday, the Dow slumped over 1,100 points on Monday to post its biggest ever points-loss. Of course, 1,000 points isn’t what it used to be. But put another way, all the US majors ended over 4% down on the first trading session of this week. The pull-back has been sudden, severe and yet controlled. We didn’t see the kind of “flash crash” in stock indices that some commentators feared would be the result of a sudden spike higher in volatility, even though algorithmic trading plays a bigger part in market activity than ever before.

Volatility soars

On Monday US stock market volatility as measured by the VIX increased by over 100% even as the S&P500 (on which the VIX is based) fell “only” 4% in the session. This led to some crushing losses for investors who have been (very profitably) selling volatility for many months. But it looks as if the damage has been contained and so far, it doesn’t appear to have threatened the stability of the wider market even though so much of the short-volatility trade was done using leverage.

Waiting for smoke to clear

Nevertheless, when markets experience this kind of turbulence it often takes time to see what the longer-term repercussions may be. The question is whether there’s been some serious damage done, either in terms of breaches of key technical trading levels or a change in overall market sentiment. Considering one factor playing into sentiment: some are asking if the sell-off means that central banks are less likely to want to tighten monetary policy this year. It was interesting that expectations for a May rate hike from the Bank of England (BoE) fell to 37% on Monday, down from 46% at the end of last week. However, sentiment flipped again earlier today when the BoE released an un expectedly hawkish statement on monetary policy.

Inflation and fiscal stimulus

But more importantly is what this means for the Federal Reserve. Recently, inflation concerns have raised the prospect that the Fed will hike rates more aggressively this year than previously forecast. Trump’s fiscal stimulus in the form of tax cuts, regulatory reform and planned infrastructure spending come on top of the lowest unemployment rate since 2001. There’s evidence of a synchronised pick-up in global growth and last week’s strong Average Earnings number further increased the prospect of a rapid rise in inflation. Consequently, there has been speculation that the US central bank will look to raise rates by 100 basis points rather than the 75 basis points suggested in December’s FOMC Summary of Economic Projections.

Fed to tighten further

But the equity market sell-off has spooked investors and led many to speculate that the Fed may decide to pull back from hiking rates aggressively this year. However, this week Bill Dudley, President of the Federal Reserve Bank of New York, dismissed the stock market sell-off as being of little consequence to central bankers. Meanwhile Dallas Fed President Robert Kaplan told the Financial Times that market volatility could be healthy and that he was sticking with his forecast of three rate hikes in 2018. So, the implication is that it would take a lot more than a doubling of volatility and a 1,000-point sell-off to throw the Fed off its current path of monetary tightening.

Planning for the next recession

Anyway, what if the Fed’s monetary tightening in the form of rate increases and balance sheet reduction is going to happen anyway, no matter what the inflation and growth outlook? What if the Fed is thinking ahead to the next recession and is desperate to build up ammunition for when it must slash rates again in response? It’s also worth considering that this market was already selling off before Friday’s big slump on the back of rising bond yields. In the space of a month the yield on the US 10-year Treasury note had risen from below 2.5% to close to 2.9%. While this week’s sell-off in equities saw yields drop back sharply as investors sought out safety of US Treasuries, the 10-year yield is once again approaching 2.9% and giving every indication the new key level of 3.0% is about to be tested. If so, then we can expect global equities to take another hit as investors panic about the prospect of higher rates on highly leveraged and over-indebted markets.

Keep it simple

From a technical perspective it’s vitally important to take a step back from the day-to-day (let alone the intra-day) fluctuations. For that reason, it’s sensible to look at the weekly and monthly charts as well as the dailies. Looking ahead to Friday’s close, keeping it simple and focusing on the S&P 500 I’m looking at the following: a close above 2,700 would be bullish and suggest that the S&P could push up to retest the highs. A close below 2,600 suggests more trouble ahead. Here’s a chart I tweeted earlier:

Daily S&P500:

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