After years of stubbornly low inflation across global markets, we are suddenly starting to see signs of this ticking higher, triggering a long-awaited selloff and a surge in volatility. As a result, panic has spread amongst investors in fear that financial markets may be overheated. In our view, the selloff has been driven by three compounding factors.
Rotation – weakness began last week as pension funds rebalanced out of equities and into bonds after a strong rally in equities in January. According to Morgan Stanley, Goldman Sachs and Credit Suisse, the volume of pension rebalancing that was expected to occur at the end of January was estimated to be one of the largest on record.
To illustrate this, simply consider a typical globally invested 60/40 balanced fund. Equity markets moved sharply higher in January (the S&P 500 was up over 5% in January alone!), causing a drift away from the strategic asset allocation mix. As a result, pension funds were forced to sell equities and buy bonds in order to re-establish the desired mix. Of vital importance here – this selling of equities is not fundamentally driven, rather technically driven.
Robot trading – compounding the outflows, this large scale of equity selling alerted circuit breakers on algorithmic trading, triggering mounting selling from trend-following strategies. Not unlike the pension outflows, such strategies trade strictly on market technicals without considering context of the greater economic backdrop.
Retail – our channel checks across trading desks is that the selling has been overwhelmingly retail, and that institutional market participants have been net buyers. Indeed, we saw several robo-advisors forced to shut down operations on Monday, leaving investors unable to execute trades due to overwhelming activity. In our view, without the help of an advisor to talk investors through such market events, we are seeing an increase in panic selling, only exacerbating the situation.
Our thoughts on the current environment
If there is one point we wish to drive home – this selloff is not fundamentally driven and this is not a repeat of 2008 where we witnessed a credit event and a housing-related issue (sub-prime mortgage market collapse). In fact, fourth quarter earnings season in the U.S. has been exceptionally strong, with the S&P 500 on track for the largest number beats this cycle. We still have an environment with coordinated global economic growth, and as long as market volatility does not erode broader confidence, the underlying fundamental picture remains supportive. If anything, we see such extreme bouts of volatility as an opportunity for active managers to capture alpha in oversold positions.
Market corrections are normal, and in fact healthy 5% corrections occur on average three times per year. It is our belief that markets will fully recover to new highs, though we stress a disciplined approach will be key as a recovery from this correction may take months, not weeks.
If you have any questions or concerns, please give us a call.