After several years’ absence, volatility returned to global equity markets this week with a vengeance. Investors were spooked by rising interest rates in the U.S. and a growing U.S. federal deficit. Intraday moves of several hundred points in either direction were not uncommon. And although they rallied for a positive trading day on Friday, U.S. stocks finished the week down significantly, the largest weekly decline since the end of the financial crisis of 2008-09.
As they have all week, Co-Chief Investment Officers (CIOs) Victor Zhang and David MacEwen provide an overview of the turbulent market backdrop. We also offer an international take from Keith Creveling, co-CIO, Global Growth Equity; a value perspective from Phillip Davidson, CIO, Global Value Equity; and insights on asset allocation from Rich Weiss, CIO, Multi-Asset Strategies.
We have a growing economy, strong corporate profits, higher wages. Victor, why are stocks plunging in the wake of this positive news?
Zhang: The stock market is in a long-overdue correction. Returns had been unusually strong for an extended period of time, and volatility had been uncharacteristically suppressed. A pullback was becoming increasingly likely.
At the same time, we have a stronger economy, growing wages, and tax cuts. This combination of factors has lifted inflation expectations and Treasury yields. For years, inflation has remained subdued and Treasury yields have remained historically low—providing an ideal backdrop for equity market gains. Now, investors believe that backdrop is likely to change, and it’s disrupting the markets.
But inflation is still below 2%, so why the concern?
Zhang: Current inflation remains low, but investors fear it may be picking up. Last week, the Labor Department reported the strongest year-over-year wage growth in nearly nine years. Rising wages have emerged as a serious threat to investors’ “goldilocks” scenario of gross domestic product (GDP) growth without the pain of inflation.
If inflation picks up too quickly, it could squeeze profits and raise the cost of capital. Investors also fear rising inflation will cause the Federal Reserve (the Fed) to hike interest rates more aggressively than expected, which potentially could lead to a slowdown in the U.S. economy and spill over into the broader global economy.
Dave, is there any indication the Fed is going to take a more aggressive approach?
MacEwen: We still expect the Fed to raise interest rates three times in 2018—a course the Fed announced in December and reiterated in January. And although yields on longer-maturity Treasuries are flirting with two-year highs, we do not believe inflationary pressures are strong enough to drive interest rates significantly higher, at least in the near term.
We also believe part of the Fed’s strategy is to pursue monetary policy “normalization” regardless of stock market movements. In the years immediately following the financial crisis, investors often would look to the Fed to cushion stock market sell-offs and support risk assets. But those days appear to be over. Recent comments from the Fed suggest the central bank believes the stock market is experiencing an inevitable adjustment to stronger global growth, rising bond yields, and tighter monetary policy.
Of course, the Fed will be monitoring economic and inflation data closely. If the current stock market volatility eventually hinders the prospects for economic growth and/or inflation, we would expect the Fed to alter its tightening strategy.
There were signs of the sell-off spilling over into the credit markets on Friday. What does this mean for investors?
MacEwen: Credit spreads (the difference in yield between corporate bonds, emerging markets debt, securitized bonds, etc., and U.S Treasury securities of similar maturity) widened modestly Friday, indicating a sell-off among high-yield and other riskier bonds. Because this spread widening followed rather than preceded the stock market slide, we do not believe it indicates investors are concerned about the financial health of corporations. Instead, we think it’s primarily a reaction to mounting volatility and the overall “risk-off” sentiment. In addition, similar to stocks, high-yield bonds have experienced a strong and extended performance run, so a sell-off is not unusual.
Keith, what should global investors take away from the spike in volatility this week?
Creveling: We think it is important to take a step back and focus on the bigger picture. As Victor mentioned, the markets were probably overdue for a correction like this after an unprecedented rally that ran almost unbroken since the end of the financial crisis amid historically low volatility. These kinds of pullbacks, while painful and a bit frightening in the short-term, are normal and to be expected. The fact that this one was so long overdue—and that many investors had seemingly forgotten that markets go down sometimes as well as up—contributed to investors’ discomfort.
We also encourage investors to concentrate on fundamentals. Despite the increase in U.S. interest rates that helped spark the sell-off this week, the U.S. economy remains sound. Employment and wage data are positive, and corporate earnings are rising. The decline in U.S. equities spilled over to non-U.S. markets as concerns grew about U.S. rates and inflation rising faster than originally anticipated and the potential for a slowing of the U.S. economic engine.
However, we remind investors that Europe and Japan are still enjoying economic growth and corporate earnings growth in an environment of accommodative government and central bank policies. Emerging markets remain attractive, in our view, supported by strong domestic fundamentals and compelling relative valuations.
Phil, what moves might you make for your value-oriented portfolios in this environment?
Davidson: As equity managers, our philosophy is to be fully invested. Each day we look to improve our portfolios and that tends to be at a measured pace. Historically, heightened levels of volatility usually provide more opportunities for value managers. However, sharp declines often initially lead to selloffs in the higher-quality, large-cap names we find attractive. Their liquidity makes them easier to sell for those looking to reduce their equity exposure. The overall selloff we’ve seen this week was not severe enough to create the magnitude of outsized irrational inefficiencies that occur in deeper corrections. Within these opportunities, some of them occurred intraday, giving us a small window to build positions advantageously.
Rich, how do you think about these current challenges from the point of view of portfolio diversification and risk management?
Weiss: We should start by acknowledging that the financial press is filled with sensational headlines about a stock market meltdown, and investors are understandably concerned and wondering what they should do. And after almost a decade of uninterrupted gains, it is easy for investors to forget that markets go down as well as up.
But we want to reiterate that these are not the sorts of things that should guide your financial planning. There is plenty of research that shows that the success of your financial plan is largely due to things you control—your savings rate, your mix of stocks and bonds, and how well you stick to your plan during times of crisis. Indeed, many individual investors experience returns that lag those of the overall market because they tend to buy after rallies and sell after declines, precisely the opposite of what a well-structured investment plan would have you do.
So, if you have a saving and investing plan to meet well-defined goals, the chances are good that your best strategy is to stick to your financial plan, or to make at most only modest adjustments to your allocation. The point is, having established investment allocations provides a framework and structure for making decisions when the markets move—whether you should buy or sell or do nothing at all isn’t a decision made in a vacuum, nor in response to screaming headlines, but one you make in the context of your unique financial circumstances.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
The opinions expressed are those of our chief investment officers and are no guarantee of the future performance of any American Century Investments fund.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.