Markets Newsflash A word on the sudden slump of the markets…

08/02/2018

ROAD LANDSCAPE shutterstock_121884964©Yiorgos GR

The equity markets have been delivering a major correction over the last few days, abandoning the high points attained during January and cancelling out all the increase made since the start of the year.

This movement of correction has been led by the American market, with the S&P index down 4.1% at close on 5 February, losing more than 6% in two sessions.

The slump of the markets and the descent below thresholds on key indexes have triggered movements on the systematic funds (CTA strategies* and risk parity funds** which in turn have the effect of accelerating the fall of the markets.

Also, this fall is particularly synchronized across all asset classes: it has involved high volumes (increasing by 54% on equity) and has been accompanied by an increase of more than 100% in volatility, with VIX*** up 37.3 at close on 5 February (biggest rise in the history of VIX).

 

What is the cause of the recent downturn of the markets ?

The main catalyst can be found in interest rates and in their upward trend that started in 2017 and has been accelerating since the start of the year, fed by resurgent fears of inflation.

Over the last few weeks, the increase in interest rates has intensified in response to the favourable economic statistics and to the figures for inflation, culminating in publication of the report on US employment on 2 February 2018, showing (at long last) an increase in wages.

In other words, this good report on employment in the United States, which is good news from a macroeconomic point of view, has resulted in bad news on the markets. The reason is that the increase in wages has prompted investors to fear stronger inflationary pressures than anticipated.

For example, interest rates have risen 45 basis points in the United States since the beginning of the year, reaching a high point of 2.85% on Friday, undermining the recent progress on the risk-assets markets.

The sharp drop in stock exchange indexes yesterday, which has continued today on the European markets, has reversed the recent trend of interest rates. Given the massive scale of the downturn, the instinct to seek refuge in safe haven assets has taken over, leading to a marked sharp slump in fixed-income interest levels. The US 10-year rate is back to the levels of 2.70% during pre-market trading on the American markets on Tuesday.

 

Does this tumbling of the markets give us reason to question our scenario, and does it herald a new negative trend on the risk-assets markets?

The fundamental environment is, in our view, still very favourable to risky assets. Equity markets should continue to be buoyed by the positive trend of rising profits. The consensus today predicts 16% growth in earnings per share in the United States (that is to say +6% since the beginning of the year) and new upward revisions are expected.

The environment of rising interest rates, accompanying the rise in inflation figures and the expected decrease in support from central banks over the course of this year is source of volatility. The current episode confirms this scenario, illustrating the necessary adjustment to new balances on the market.

However, this environment is not of a nature to cause any sustainable reverse of the favourable trend of risk-assets markets, since the trend in interest rates is expected to be contained.

In this context of renewed volatility, we are keeping a particularly close watch on the next set of inflation figures.

 

* Strategies deployed by alternative funds which importantly uses derivatives to generate performance
** Fund aiming at equilibrate contributions by risk for each assets in portfolio

*** Implied volatility indicator of the S&P500 index

 

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