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Back to normality

The strong start into the year left markets vulnerable. However, we remain constructive due to solid economic fundamentals.

It's been quite a market correction, these past two days. On this, at least everybody can agree. But as soon as you try to put things into perspective, opinions diverge. As an extreme example, consider Bitcoin. By many, the cryptocurrency's swift ascent was seen as evidence of market exuberance and carelessness. Since its peak in the middle of December, the price of Bitcoins has fallen by about 70%. That sounds dramatic. But it leaves Bitcoin pretty much where it was trading at the beginning of November – only three months ago. That sounds a lot less scary.

The patterns in most equity markets are similar. The MSCI AC World Index, for example, is still showing gains for the year. To be sure, a few indices suffered the "worst daily decline in their history." However, that's only true if you look at the decline in index points, and mainly due to the rapid share price gains we have seen in recent years. In percentage points, corrections of 4%, as recorded in the S&P 500 on Monday, are not at all unusual by historic standards. What was unusual was that the main U.S. equity index had not seen any five percent correction for more than 400 days. Already, this long period of steady gains had surpassed the previous record of 395 days from 1996.

This observation is important, and not just in terms of the frequently mentioned suggestion that some sort of correction has long been overdue. It also helps to explain the virulence of recent price movements. The long upward trend, together with solid economic figures, caused market volatility to be unusually low, for unusually long. The recent doubling of the Vix, which measures the volatility implied by S&P 500 index options, has finally driven investors out of their comfort zone. The Vix is now at levels last seen in 2011. This increase in volatility expectations has important implications for many investment strategies.

We think that much of the market movements of recent days has been due to self-reinforcing portfolio repositioning and forced selling by certain trading strategies. This includes short selling of volatility options, as well as funds with binding risk targets. Many momentum driven strategies are also having to reposition themselves. This could take a couple of days and could cause markets to overshoot. We would probably use such movements to increase our holdings in equities and selected bonds.

A justified warning shot

Perhaps, the latest strong U.S. employment report, newly rekindled inflation fears and ensuing concerns that interest rates might rise more swiftly than expected, are some of the causes of the correction. These concerns do have some justifications, but one should not overdo it either. The U.S. unemployment rate is near lows only seen a few times in the post-war period. Wage growth has been accelerating for the last few quarters, even if it remains quite moderate. A few sectors have experienced difficulties at filling vacancies. All this is why we would not fully dismiss the risk of a sudden jump in wage growth. However, our base case remains a continuation of the pattern we have seen in recent years. We expect U.S. core inflation to accelerate to a moderate 1.8%, from 1.5% in 2017. Based on this, we only see scope for 3 Fed rate hikes by the end of this year.

Because of rising inflation concerns, we could also see a negative reassessment of recent U.S. tax cuts in bond markets. The dangers of deficit financed tax reductions at this stage of the economic cycle have certainly become more apparent.

Outlook – global growth should support markets

We maintain our positive outlook for most equity markets and do not expect bond yields to continue to rise at their recent pace.

We view it as unlikely that bond yields on 10-year U.S. Treasuries will trade above 3% by the end of the year, or that equivalent Bund yields will be above 1%. Yields on government bonds have even declined in recent days. This confirms their status as a safe harbor in turbulent times. We continue to see them as a suitable instrument to consider when managing overall portfolio risk. We also take comfort from the relative calm in corporate bond markets, where we have observed no signs of market stress. Default rates remain near zero.

For equities, we also maintain our year-end targets (Dax: 14,100 and S&P: 2,750). However, recent events confirm our view that 2018 is likely to be more turbulent than the calm seen in recent years. Investors have to reacquaint themselves with inflation. In one important respect, this correction has certainly been different from others we have seen in recent years. The presumed trigger was not bad news on the economic outlook, but more optimistic readings. For the first time in quite a while, the danger of the U.S. economy overheating has moved into sharp focus. At the same time, equity investors have to get used to another recent development. Given the rise in yields on U.S. Treasuries, equities no longer look like "there is no alternative." In less than two years, yields on two-year Treasuries have risen from 0.5% to 2% and now once again exceed the dividend yield of the S&P 500. We have already taken this into account for our index targets, which incorporate a slight contraction in earnings multiples.

Overall, we remain constructive for equities, due to the synchronized global recovery, which we expect to underpin strong earnings growth. Given that until recently, investor sentiment was near record highs, we think that some sort of correction was indeed overdue. For stock pickers, such phases can certainly bring opportunities.

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