The US stock market is now closed, with the S&P 500 falling around 2 3/4%. The Nasdaq was down over 3% and the Dow was the big loser, down over 4%. We are now officially in correction territory because stocks are down more than 10%. The question everyone is asking is whether the volatility is over. I don’t think it is, but let me make some points on the economy.
First, on the market, if you had looked at the market around 3PM, the market was down but it wasn’t terrible. But then there was heavy selling into the close and the losses doubled overnight. That’s a clear sign of forced selling, potentially driven by the negative volatility trade.
When I looked at the fundamentals of the economy this morning though, things were really good. So good that I noted the stimulus plans as a net negative for bonds. Right from the start, we saw pressure on bonds. And as soon as bonds sold off, equities began to sell off too — as if rising yields are driving a fear in equity markets that bond yields are poised to rise dramatically. At some point, however, bonds rallied again, and the pressure on equities eased as well, before the selling into the close. Bonds ended the day largely unchanged.
Every time yields rise, stocks fall, volatility indices rise. And then yields fall again, before stabilizing. We seem to be trying to find a bond yield level that will allow equities to find some stability. But that’s not possible with the short volatility trade getting weeded out of the market. I think all of this will continue for a while. And the first piece of real data we get on inflation comes in the middle of next week, with the Consumer Price Index on Wednesday. Since this volatility seems to be inflation-related, this will be a good marker.
By the way, the last time, we saw bonds and stocks moving in concert was during the financial crisis. Usually they move in opposite directions as people rotate out of equities into bonds and vice versa. When both markets are falling at the same time, there is nowhere to hide. And this is especially true now because the volatility has infected credit markets with implied spreads of high yield credit default swaps moving higher.
On Tuesday credit markets seemed very calm relative to equities. Today’s a little different – implied high-yield bond spreads are rising rapidly, according to this credit-default swaps index. pic.twitter.com/KXUfbIsr7Z
— Lisa Abramowicz (@lisaabramowicz1)
Through all of this, the real economy outlook remains positive. You will have noticed in the morning note today that Evercore sees real GDP growth in the US moving from 2.0% to 2.7% on the back of tax cuts and proposed increased government spending. Nowcasts for GDP growth are good, consumption remains robust, and wages are rising. The New York Fed’s model shows a recession probability that is rising, but is still only 10% through the end of 2018.
Source: NY Fed
The bottom line is that the economic fundamentals are good.
If you recall, Jeremy Grantham encapsulates his worry about a melt-up in the phrase “wonderful fundamentals, euphorically extrapolated”. So while the fundamentals remain good, the extrapolation of those fundamentals is coming under assault. Inflation is certainly one reason why. Corporate earnings are not. Most companies have already reported, with 78% topping estimates, with earnings growing 14.7% and revenue up 8% on year ago levels. Those are good numbers.
For now, I’m not particularly worried. When the fundamentals take a knock, that’s when we should worry. Let’s wait for the CPI next week and revisit this conversation. Markets are expecting 2.1%, year-on-year. If this number is unexpectedly high, we will see bonds sell off, and stocks probably along with them.
P.S. – Notice that the Fed’s recession probability index soars before a recession hits. It’s not a failsafe indicator but we don’t get recessions out of the blue either. The data encapsulated in the Fed’s recession probability calculator suggest smooth sailing economically for the near-term.
P.P.S. – one facet of market selloffs is contagion. And this comes from investors reassessing risk. With people suggesting too many investors were effectively short volatility, many without even knowing it, investors are checking their portfolios for other signs of potential risk. One risk is in the form of ‘fake liquidity’ provided by ETFs for illiquid underlying markets like high yield bonds or leveraged loans. So far, we have seen limited contagion into markets like these. The uptick in implied spreads in high yield CDS is one sign, though, that contagion risk is rising.