Market volatility returned with a vengeance on Monday, with the S&P closing 4.1% lower for the day and 7.8% below its all-time high in January - wiping out gains for the year. In our view, this pullback is a clear indication that the historically calm market conditions experienced in 2017 are over.
In line with the 2018 outlook we released last month, we expect volatility to pick up and stock market returns to moderate this year. We do not view the recent turbulence as a reason to become defensive or an indication that we are on the cusp of an economic downturn.
We continue to see solid economic growth in the US and abroad, stronger corporate earnings and financial conditions that are gradually tightening but should remain supportive for some time.
As the calendar flipped to 2018, equity investors focused on the potential benefits of the tax reform bill passed in December, propelling stocks to a record-setting start to the year. On the flip side, bond markets started to worry about rising inflation and larger fiscal deficits, causing 10-year Treasury yields in January to post their largest monthly rise since November of 2016.
Bond markets came under additional pressure last Wednesday on the heels of a more hawkish Federal Reserve statement, and again on Friday with an unexpectedly strong wage growth report. These developments pushed the 10-year Treasury yield up 14 basis points to 2.84% between Wednesday and Friday, following the increase of 30 basis points in January.
The spillover into equity markets began Friday and intensified on Monday. After a brief move to positive territory yesterday morning, markets came under extreme pressure as the S&P 500 fell nearly 4.5% from the intra-day high. We would consider it likely that a large portion of the spike in volatility and slide in stocks yesterday could be attributed algorithmic trading strategies, exchange traded products levered to volatility, and other technical dynamics.
In the early hours of trading today, US markets are demonstrating resilience.
While it is too early to declare this bout of market volatility over, we remain confident about economic fundamentals and the corporate backdrop at home and abroad. Therefore, we are comfortable favoring equities over fixed income. We view this recent drawdown - the largest in nearly two years - as healthy, and as an opportunity, rather than a reason to become defensive.
Viraj Patel, Head of Asset Allocation, and Kyle Hutchinson, Assistant Vice President, Asset Allocation, contributed to this article.
