Volatility Is Coming: Here's Where We Are Today
Summary
- With global political uncertainty rising and big decisions to come, markets are biding time.
- Global central bank policies are at a point where tightening will start playing a bigger role and easing will begin to slow.
- Valuations are playing less of a role in equity markets.
Global risks and uncertainty are rising and consolidation is coming. The GOP tax plan, Catalonia's fight for independence, a new Fed chair and central bank policy decisions are all big factors that will bring volatility into the market in the coming weeks. Many articles and radio shows in the last few months have mentioned a paradigm shift which has taken place - one with a lower focus on valuations and bigger focus on relative growth prospects. This speculation based on relative growth has pushed equity markets to record highs globally.
In the United States, forward P/Es have broken out above the rest of the world, signaling extreme optimism in American equities. That bullishness usually does come in times of expansion such as the current bull market. However, this bull market has some different features.
Source: Yardeni Research, Inc.
Market Breadth
The issue behind this expansion of P/Es beyond global indices has been the breadth of growth in the United States. Breadth has been near all-time lows in large part due to tech stocks. Below is a chart of market breadth comparing the S&P 500 and the SPDR Technology Sector ETF (XLK) in orange. Below is a popular gauge of breadth, the ARMS Index.
Central Bank Policy
In the upcoming weeks, investors are expecting a new Fed chair, balance sheet deleveraging, continued rate decisions, and global central bank policy decisions. As global inflation begins to slowly creep back into the markets, the risks of deleveraging and tightening globally are expected to bring increased risk and volatility into the markets. Inflation creeping back into the markets gives central bankers the rationale to continue tightening and start restricting the flow of credit that could alter companies' capital expenditure plans which will be reflected on the bottom line in the next 8-12 quarters of earnings.
Government Agenda
As politics continues to play a bigger role in the investment community, the Trump trade still appears to be priced in. Markets appear to be expecting the pro-business agenda the administration has preached. Should the tax plan fold on the hill, small-caps, the biggest beneficiaries of a decreased corporate tax, will see some volatility.
Last week, the administration held a press conference regarding opioid use in pharmaceuticals and the drug epidemic in the United States. Healthcare and pharma stocks took a dip after the conference and are still struggling to recover those losses. If the administration began pushing for legislation or increased regulation on pharma, this would just be another risk leading to increased volatility in the market.
Investment Philosophies
As of the last few quarters of earnings, "beats" and "misses" have usually led to extreme overreactions by the market. The slight correction in the following days leads me to believe that after a beat or miss, the flow of investment spikes and then corrects itself by week's end. This paradigm appears to me as no longer investment but speculation. This rampant speculation will continue to push P/Es through records until one of the risks mentioned above or global uncertainty kicks in.
Where Do We Go From Here?
Global risks are not being fairly compensated for. The excessive bullishness in American equities appears to make US equities less attractive relative to global equities. I think that better valuations and higher returns are present in EM. I believe the risks relative to value are equal/more favorable to EM equities than US equities.
Strong economic data and the prospects of the tax plan will be bullish for the dollar. Over the last two months, the Dollar Spot Index (DXY) has shown some resilience. Strong economic growth will continue to push the dollar further.
Expect safe-haven assets to see a bounce in the upcoming months. As global risks rise, investors flock to gold and Japanese yen.
This article was written by
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