published: June, 12th 2017
Market Update – June 12, 2017
I thought I would send out a quick market update given the price action on Friday, where we saw technology stocks sell off fairly aggressively while financials rallied. The price action in tech has carried over to Asia and Europe and has been a continued modest headwind to market futures. The drivers of this on the financials side are primarily policy related as Friday’s bank regulatory outcomes (passage of the Choice Act in the House, release of slight regulatory concessions by Treasury) and slightly better odds of corporate tax reform have been a bullish signal for that sector. Meanwhile, the 10 year treasury climbing back into the 2.20% range is helping sentiment for the financials given the importance of the shape of the yield curve to their business model. Also, on the tech front, please keep in mind that we have seen that space rally pretty aggressively, and so from a technical standpoint there may be some room for some consolidation of gains.
The Fed will vote on a rate increase later this week, and it is widely expected that they will raise interest rates by another quarter percent (84% odds according to the futures curves). What will be more interesting is the shape of the dot plot, and any commentary they give on how and when they will begin to reduce the size of their balance sheet. On the former, keep in mind that recent economic data on both employment and inflation has been a little weaker than expected, which is lowering the chance for four rate hikes this year. On the latter, speculation is pretty wide as to the timing and structure of a balance sheet reduction – JP Morgan is looking for a December start while Goldman Sachs is thinking September. Regardless of when they choose to start contracting the balance sheet, they will do so by simply not reinvesting proceeds as bonds they hold mature. This could put additional pressure on the fixed income market (could push interest rates higher), although my sense is that the fed wouldn’t mind seeing the 10 year a little higher than we are today.
A lot has been written about the collapse of volatility in the market given that the VIX is now below 10. While some of the best work that I’ve seen on the topic discusses some structural reasons for the decline (such as the rise of passive investing and the relative lack of leverage in the market / abundance of cash on the sidelines), I believe that the vast majority of the reason for the recent decline has been a real lack of any type of economic volatility over the past 12 months. By almost any measure, the level of “surprises” in the economic data has been exceptionally low, and we’ve seen growing Gross Domestic Product / earnings / wages / inflation on a macro level which are all conducive to positive stock market returns. This is true globally. The risks to the market have primarily been geopolitical, and those shocks and concerns have been largely swept aside in the face of the positive macro picture. That’s a long winded way of saying that I do not believe that volatility is dead, but rather it’s “sleeping” until we start to get a shake up in the economic picture.
As a practical matter, I would note that since volatility has been so low for so long, many of the risk scoring software platforms are showing incredibly low downside tolerance numbers for what have been more traditionally volatile asset classes. This is particularly true for leveraged loans and high yield. We plan to add some risk to our income sleeves to compensate, as many of the income models are now testing out at 300-400bps* below their target levels, however I am hesitant to bring them up fully to the targets as I believe the volatility levels that are being measured are unusually depressed (for the reasons I outlined above). If you are building / scoring your own models with high yield income exposure, I would encourage you to think about the volatility over a longer time frame versus just the past twelve months.
Have a great week!!
Rick Wedell is neither affiliated with nor endorsed by LPL Financial.
*Basis points. One basis point is equal to 1/100th of 1%, or 0.01%
The CBOE Volatility Index® (VIX®) is meant to be forward looking, showing the market's expectation of 30-day volatility in either direction, and is considered by many to be a barometer of investor sentiment and market volatility, commonly referred to as “Investor Fear Gauge”. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. Investing involves risk including loss of principal.