Volatility Returns

Markets have been resilient for quite some time, fueled by broad-based global economic growth and strong corporate earnings. The S&P 500 index is coming off a stellar year and is up over 300% in the nine years since the financial crisis. This upward momentum continued during the first four weeks of 2018, with sentiment readings reaching extreme optimism, as investors feared missing out on the market’s climb.

It seems reasonable then that the U.S. equity market, which had gone over 400 days without a 5% pullback, was overdue for one. The stock market sell-off last week was largely a result of a sharp rise in interest rates fueled by strong growth and increased inflation expectations. Friday’s jobs report, which showed the fastest wage growth since 2009, raised speculation that the Federal Reserve may have to increase short-term interest rates at a quicker pace than originally anticipated. The S&P 500 index suffered its worst week since January 2016, while international equities declined by a lesser degree. The 10-year Treasury note yield, which began the week at 2.66%, closed nearly 20 basis points higher at 2.85%. Meanwhile, the extraordinary period of calm witnessed last year gave way to an uptick in volatility, with the CBOE Volatility Index (VIX), closing above 16 for the first time since the U.S. presidential election.

A Tug of War

The U.S. equity market is weighing an improved outlook for global growth and double-digit earnings against a pickup in inflation expectations and interest rates. Given the momentum in economic indicators and easy financial conditions, we expect our central theme of synchronized global growth will remain intact. Our outlook is for real gross domestic product for the U.S. and the world to come in at 2.7% and 3.8%, respectively. Additionally, the boost from the recent tax cuts should support our outlook for an earnings-driven equity market.

Despite the better-than-expected fourth quarter earnings to date, investors have become more concerned with signs of inflation and whether the move higher in rates would stifle the equity market. Similar to past economic cycles, a gradual drift higher in inflation, as well as modestly higher short- and long-term interest rates, is normal at this point in the economic cycle. Even though the rise in the 10-year Treasury note occurred quickly, we would not be surprised to see rates continue to drift higher over the next few quarters only to come down again. In the end, we expect earnings and growth will win this tug of war as markets adapt to higher rates.

Investment Implications

In our view, synchronized global growth and stronger earnings will continue to provide an equity-friendly environment. All bull markets go through these periods of pullback, but we believe this one will turn out to be a correction and not the beginning of the end. Although volatility may persist in the near term, this weakness may present buying or reallocation opportunities at lower prices. We believe investor portfolios are well positioned and will benefit from our emphasis on diversification, rebalancing and customized hedging strategies during this period of rising rates and volatility. We will continue to watch valuations, inflation, the shape of the yield curve and credit spreads for signs of a market top — but we just don’t see signs of it yet.

  • This white paper is the property of BNY Mellon and the information contained herein is confidential. This white paper, either in whole or in part, must not be reproduced or disclosed to others or used for purposes other than that for which it has been supplied without the prior written permission of BNY Mellon. This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. The Bank of New York Mellon, Hong Kong branch is an authorized institution within the meaning of the Banking Ordinance (Cap.155 of the Laws of Hong Kong) and a registered institution (CE No. AIG365) under the Securities and Futures Ordinance (Cap.571 of the Laws of Hong Kong) carrying on Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities. The Bank of New York Mellon, DIFC Branch (the “Authorised Firm") is communicating these materials on behalf of The Bank of New York Mellon. The Bank of New York Mellon is a wholly owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients only and no other person should act upon it. The Authorised Firm is regulated by the Dubai Financial Services Authority and is located at Dubai International Financial Centre, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the Federal Reserve and authorised by the Prudential Regulation Authority. The Bank of New York Mellon London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon is incorporated with limited liability in the State of New York, USA. Head Office: 225 Liberty Street, New York, NY 10286, USA. In the U.K. a number of the services associated with BNY Mellon Wealth Management's Family Office Services– International are provided through The Bank of New York Mellon, London Branch, 160 Queen Victoria Street, London, EC4V 4LA. The London Branch is registered in England and Wales with FC No. 005522 and #BR000818. Investment management services are offered through BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA, which is registered in England No. 1118580 and is authorised and regulated by the Financial Conduct Authority. Offshore trust and administration services are through BNY Mellon Trust Company (Cayman) Ltd. This document is issued in the U.K. by The Bank of New York Mellon. In the United States the information provided within this document is for use by professional investors. This material is a financial promotion in the UK and EMEA. This material, and the statements contained herein, are not an offer or solicitation to buy or sell any products (including financial products) or services or to participate in any particular strategy mentioned and should not be construed as such. BNY Mellon Fund Services (Ireland) Limited is regulated by the Central Bank of Ireland BNY Mellon Investment Servicing (International) Limited is regulated by the Central Bank of Ireland. BNY Mellon Wealth Management, Advisory Services, Inc. is registered as a portfolio manager and exempt market dealer in each province of Canada, and is registered as an investment fund manager in Ontario, Quebec, and Newfoundland & Labrador. Its principal regulator is the Ontario Securities Commission and is subject to Canadian and provincial laws. BNY Mellon, National Association is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. BNY Mellon is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept any responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. Trademarks and logos belong to their respective owners. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.

    © 2018 The Bank of New York Mellon Corporation. All rights reserved. M151935