Don't Call it a Comeback
On Friday, September 9, the S&P 500 lost 2.45%, marking the first daily move of 1% or more since July 8 of this year. At that time, the market was still bouncing back from a shocking Brexit vote. A remarkably calm "summer doldrums" period followed, lasting more than two months. Since then, and through this Friday, four out the last six trading days have resulted in 1%+ market swings (see chart above with year-to-date performance of the CBOE Volatility Index which tracks S&P 500 volatility). The volatility that ushered in 2016, and that the Brits brought back to the party, is making its third appearance this year. Let’s explore some of the themes that are giving rise to volatility and rise and fall to the market.
Will they, or won’t they raise rates? We have dedicated the better part of the last two weekly emails discussing Federal Reserve monetary policy and various Fed members’ comments. On Monday, another member, Atlanta Federal Reserve Bank President Dennis Lockhart, remarked that a “lively discussion” of a rate hike was warranted at next Wednesday’s FOMC meeting. Ahead of that September 21st meeting, investors have been combing through economic data to glean some insight. Disappointing August retail sales and weak industrial production helped a rally on Thursday while US consumer sentiment was flat and the consumer price index slightly exceeded expectations (up 0.2% for August) on Friday. CME Group’s FedWatch tool, as of Friday, has the current probability of a September rate hike at 15% and 45% before year-end.
In light of recent comments by Fed members, bond yields have spiked. The 10-year Treasury yield is up to 1.701% from a bottom of 1.366% reached on the aforementioned July 8th and after hovering around 1.5% for the rest of the summer. It is interesting to note that recent spikes in volatility have correlated with spikes in bond yields. The opposite would have been true in the past with investors buying and driving yields down during periods of stock volatility.
Crude oil prices trended down this week with a 1.73% drop on Friday, reaching a one-month low. The main culprit is an increase in Iranian exports. The OPEC producer raised exports to more than two million barrels per day, close to pre-sanctions production of five years prior. Fed rate hike fears trickled down to oil prices, as a rise in the US dollar and falling stock prices impacted the price of the commodity.
The anchor that drags behind this year’s "market rallies" post-February low and post-Brexit has been overweights to low-risk assets, including STUBs (consumer Staples, Telecoms, Utilities, Bonds) and cash. The latest BAML survey of global fund managers shows cash levels of 5.5%. This year’s cash levels, which peaked in July at 5.8%, are the highest since post-9/11. Global equities levels are the lowest since mid-2011 and mid-2012, which marked bottoms before notable rallies. Due to the previous statistics, the cash-to-equities relative allocation sits at a four-year low.
This asset allocation is representative of the latest reading of the AAII investor sentiment survey in which pessimism reached a three-month high; 35.9% of investors surveyed described their outlook as bearish, while only 27.9% were reported as bullish. The index is a contrarian indicator, as a "bullish" level of less than 28.3% has resulted in an average S&P 500 six-month return of 6.9% and a 12-month return of 12.9% since survey conception.
As investors reach for safety, it is important to note that “low-risk” assets may prove to be "anything but" if interest rates continue to rise. The table below measures performance before and after the 10-year Treasury yield "bottom" on July 8th. Since then, traditionally beta-rich regions and sectors such as emerging markets, international, small cap, and growth assets have outperformed bonds, high dividend, low volatility, consumer staples, real estate, and utilities.