Seeing Beyond Short-Term Volatility

Key points

  • Ill-fated volatility trades exacerbated a global equity selloff partly triggered by rising rates, but we see reason to look through near-term uncertainty.
  • Last week's rout spread across equity factors, geographies and styles, but contagion to other asset classes was mostly limited.
  • A significant bump up in U.S. government spending is poised to add further upward pressure to bond yields.

A global stock selloff was exacerbated by the unravelling of strategies betting on low equity volatility. The rout was partly triggered by the quick run-up in government bond yields, yet we believe investors should take the long view amid upbeat fundamentals.

Daily moves in S&P 500 vs. VIX futures, 2007-2018

Daily moves in S&P 500 vs. VIX futures, 2007-2018

Sources: BlackRock Investment Institute, with data from Thomson Reuters, February 2018.
Notes: The chart compares daily moves in the spot VIX and S&P 500 e-mini futures since 2007.

Last Monday's spike in the U.S. equity volatility gauge was literally off the charts. See the orange dot in the upper-left corner of our chart of the week. The chart shows just how outsized the VIX surge was relative to the move in the S&P 500. The disconnect between the two was more dramatic than anything seen during the depths of the financial crisis or in the aftermath of the Brexit referendum.

The volatility spike comes at a time when market worries over increasing real bond yields (rather than over rising inflation) have taken center stage. The reason: Market perceptions are adjusting to higher U.S. growth and deficits. The S&P 500 ended the week down 9% from its record high touched on Jan. 26, bringing it back to where it was in late November 2017.

Digesting rising rates

The extreme volatility initially was limited to equities, as discussed in The stock swoon in context, but by the week's end had resulted in some credit spread widening. Rising rates and the end of the one-way volatility-selling trade suggest markets are unlikely to return to the unusually calm conditions seen last year. But, for now, we do not expect the episode to spur a regime shift. An about-face would require a deterioration in the economy and an accompanying rise in macro volatility.

We see few signs of either. Our BlackRock Growth GPS for G7 economies is at its highest levels in three years. Consensus forecasts are catching up to our GPS as the expected boost from U.S. fiscal stimulus gets baked into forecasts. We expect the rise in inflation to be modest and the Federal Reserve to tighten gradually, and see further yield rises capped by investor thirst for income and high global savings looking for a home.

A risk to our sanguine view is the potential for a swifter rise in rates as markets are waking up to stronger growth and rising budget deficits. This helped spark the equity retreat and offered a stark reminder that the pace of rate increases matters. One trigger for quickening that pace is the U.S. government's ambitious spending plan - a sea change from years of fiscal consolidation. We see this resulting in a jump in Treasury bond issuance that markets have yet to fully acknowledge. This could put more upward pressure on yields.

Higher real yields change the relative value proposition of stocks and bonds, raising the bar for equities and other risk assets as investors re-assess risk/reward. This highlights one of our key 2018 themes: We expect investors still to be compensated for taking risk - but receive lower rewards. We believe the benign economic backdrop and strong earnings momentum provide a solid foundation for putting money to work in equities. We find that equity pull-backs are short and recoveries quick in low macro volatility regimes.

  • A global equity rout led by the U.S. market spread across factors, geographies and styles. Many equity markets have now clocked a 10% fall from the high. Contagion was limited in other asset classes. A narrowing trade surplus in China and demand for U.S. dollars ahead of the Chinese New Year hit the yuan.
  • The U.S. House and Senate approved a far-reaching, two-year budget deal that significantly increases government spending. An extended government shutdown was averted.
  • A new German coalition agreement would likely see the Europe-friendly SPD taking over the key finance and foreign ministries. Bank of England comments were more hawkish than expected, supporting sterling.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps -5.1% -2.0% 13.5% 2.0%
U.S. Small Caps -4.5% -3.7% 8.6% 1.2%
Non-U.S. World -6.4% -2.7% 18.8% 3.2%
Non-U.S. Developed -6.2% -2.8% 17.9% 3.4%
Japan -5.3% -0.7% 20.0% 2.1%
Emerging -7.1% -1.3% 26.2% 2.8%
Asia ex-Japan -7.6% -2.3% 28.0% 2.6%

Bonds Week YTD 12 Months Yield
U.S. Treasuries 0.1% -1.9% -0.2% 2.9%
U.S. TIPS -0.5% -2.0% 0.1% 2.6%
U.S. Investment Grade -0.5% -2.3% 3.3% 3.6%
U.S. High Yield -1.5% -1.3% 4.1% 6.4%
U.S. Municipals 0.2% -1.4% 2.9% 2.6%
Non-U.S. Developed -0.7% 1.5% 10.6% 0.9%
Emerging Market $ Bonds -1.9% -2.5% 4.8% 5.7%

Commodities Week YTD 12 Months Level
Brent Crude Oil -8.4% -6.1% 12.9% $62.79
Gold -1.3% 1.1% 7.2% $1,317
Copper -4.1% -6.8% 16.0% $6,755

Currencies Week YTD 12 Months Level
Euro/USD -1.7% 2.1% 15.0% 1.23
USD/Yen -1.2% -3.5% -3.9% 108.80
Pound/USD -2.1% 2.3% 10.6% 1.38

Source: Bloomberg. As of Feb. 9, 2018.
Notes: Weekly data through Thursday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Table: Asset class views from a U.S. dollar perspective

This post originally appeared on the BlackRock Blog.