The Return of Volatility

Posted by FlexShares on Feb 7, 2018 12:26:47 PM


Over the last week, a lot more has changed in the financial markets than in the real economy.

Year-to-date gains in equities have been reversed and last week’s sell-off accelerated into Friday, and this Monday saw a further decline of 4% in U.S. equity indices.[1] The media has put a spotlight on this situation – one headline Monday night was “Dow plunges 1,175 points, biggest drop in history.”[2] We believe a 4% drop in equities is certainly noteworthy, but not historic.

Our opinion is that over the last couple of months, interest rates and inflation expectations have been slowly moving upward and equity markets have taken it in stride. However, we believe that last Friday’s U.S. jobs report appears to be a catalyst for the sell-off. Wage growth for January was reported at 2.9%, as compared to the recent trend of 2.5%.[3] Importantly, the prior two month wage gains were also revised up – so wages have been rising for three months in a row. We believe this raises questions in investors’ minds about the outlook for inflation and the Fed’s reaction.

We believe that there is potential that the improving global growth outlook may lead to a jump in inflation. We have been sanguine about the longer-term outlook for inflation, however, while acknowledging the potential for a cyclical bump. Fixed income markets have been gradually pricing in the possibility of a bump, as the 10-year Treasury Inflation Protected Securities (TIPS) breakeven has risen from a low of 1.67% in June to 2.09% today.[4] We have also noticed a change in investor’s concerns for the potential of a yield curve inversion (long-term rates falling below short-term rates) to concerns about a steepening yield curve (long-term rates rising with short-term rates falling.) We believe the steepening yield curve actually makes the Fed’s job easier, and markets are now discounting three rate hikes over the next year. This is what the Fed hopes to accomplish as it would allow them to raise rates, in line with market expectations.

The rapidity of the market decline in recent days is meaningful, but the exact causes are indeterminate. The price action in equities seems to indicate a significant role of computer-based traders. The accelerated declines in the last two hours of trading on Monday have the footprints of trend-following algorithms as opposed to fundamental investors. Credit markets – an excellent barometer on deteriorating economic and financial conditions – have held up well and are not showing signs of stress.

The banking system has also increased its capital from $500 billion in 2000 to $1.25 trillion,[5] significantly reducing its vulnerability to market stresses.

Equity markets had gone 80 weeks without a 5% correction (as opposed to the normal frequency of 10 weeks).[6] The abnormal evenness of the stock market over the past couple of years, we believe set investors up for a shock whenever stocks did fall at least 5%.[7] That’s because the pain of a market drop depends not merely on its size, but on its steepness relative to recent experience. Our opinion is that a 5% drop back in late 2008 or early 2009 was almost routine; now it feels like a frightening deviation. We expect that investors who have had the discipline to stick with an asset allocation approach will continue to benefit from such an approach going forward.

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Unless otherwise noted, all opinions expressed in this post are those of the author and do not necessarily represent the views of Northern Trust. Information contained herein is current as of the date appearing only and is subject to change without notice.

End Notes

[1] Bloomberg, MSCI U.S. Equities IMI Index returns 05Feb2018.

[2] Otani, A. Dow Drops More Than 1,100 Points in Stock-Market Rout. Wall Street Journal. Retrieved Feb 6, 2018 from

[3] Leubsdorf, B. U.S. Gained 200,000 Jobs in January as Wages Picked Up. Wall Street Journal. Retrieved Feb 2, 2018 from

[4] Source: Bloomberg, 10-Year Treasury Inflation Protected Securities rate 02Jan2018 - 06Feb2018.

[5] Board of Governors of the Federal Reserve System. Comprehensive Capital Analysis and Review 2017: Assessment Framework and Results. June 2017. Retrieved 05Feb2018 from

[6] Bloomberg. MSCI Emerging Market Equities Index, MSCI U.S. Equities IMI Index, MSCI World ex-U.S. IMI Index 26Jul2016 – 02Feb2018.

[7] Bloomberg, MSCI U.S. Equities IMI Index returns 05Feb2018.

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