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BLI - Banque de Luxembourg Investments’ chief investment officer Guy Wagner has published a brief comment on the recent market turbulences.
Between its intra-day high of January 26 and its intra-day low of February 6, the S&P 500 saw a decline of nearly 10%. Behind this decline were worries that the US economy is being overstimulated (with tax cuts coming in the 9th year of an economic expansion, that inflation may finally start to materialize (with average hourly earnings increasing at their strongest pace since 2010 in January) and that the Federal Reserve is behind the curve. These worries also led to a rise in the 10-year Treasury yield to 2.8%, from 2.4% at the start of the year.
The decline was amplified by technical factors in relation to a collection of investment strategies based on volatility. These strategies in effect short volatility by either selling the VIX index outright or by increasing (decreasing) equity exposure to drops (rises) in measured volatility. When volatility rises, they force volatility sellers to buy back the VIX contracts they have sold short or to sell equities. The February 5 ‘crash’ seems to have cleared out much of the retail component of this trade (Credit Suisse, which manages the VelocityShares Daily Inverse VIX Short Term ETN, thus announced that it would liquidate the fund as its indicative value had fallen by 80%), but the institutional components of the trade are still in various stages of de-leveraging.
Market correction or more?
What happened on Monday can be seen as healthy (especially after the euphoric start to the year). Bull markets have a better chance of continuing with down days in between. There is no mistaking that equity valuations are high. Conditions remain supportive for equity valuations however. The world economy remains in good shape (for now) and interest rates, though rising somewhat, remain low. Fears of rapid wage inflation seem overdone (in January, the rise in average hourly earnings was partly compensated by the fall in average weekly hours). There is currently a lot of talk about a further acceleration in US growth based on expectations that tax reform will lead to higher investment spending by companies and that President Trump’s infrastructure plan will boost public spending, but one should not forget that higher oil prices, rising interest rates and a low savings rate might weigh on consumer spending, which accounts for two thirds of GDP.