Asset Allocation Flash – A technical rather than a fundamental correction

07 Feb 2018

Summary

  • Global equities sold off aggressively as higher bond yields finally dented January’s sharp risk rally
  • The sell-off was triggered by strong hourly earnings data in the US, but its magnitude appears to have been exacerbated by technical market factors
  • Solid growth fundamentals and limited contagion from equity volatility to other markets such as rates, currencies and emerging markets (EM) are consistent with a technical dislocation in equity markets

 

Asset Allocation

  • We remain constructive on equity markets where fundamentals are strong such as Europe, Japan and EM
  • We remain underweight fixed income structurally given the risk of higher inflation and higher interest rates, but we have taken profits tactically after the sharp sell-off in Bunds

A TECHNICAL RATHER THAN FUNDAMENTAL CORRECTION

2018 started on a very strong footing as financial markets priced in a reflation environment with both risky assets and bond yields rising for most of January. Most major equity markets started correcting in late January, but it was not until Friday 2 February that the correction in risky assets deepened. This followed an upside surprise in the latest data on average hourly earnings in the US, which rose to 2.9% YoY, beating consensus estimates of 2.6%.

The correction has been aggressive, but it has been concentrated in global equity markets. Indeed, the sell-off in other risky assets has been orderly. Government bonds had been falling over the course of the month and the equity plunge has so far not led to a typical ‘flight to bond safety’ as seen in recent years. The 4% fall in the US S&P 500 equity index on 5 February is the largest daily drop since August 2011 and the spike in US implied equity volatility (as reflected in the VIX index) was the biggest since April 2009.

There are various reasons that make us believe that this correction is technically driven.

First, volatility in other markets has not spiked in a similar fashion. Rates and FX volatility, for example, had risen in January, but remain contained compared with the VIX. Other ‘high-beta’ assets such as commodities, EM currencies and bonds do not appear as dislocated.

Second, there is evidence that systematic strategies such as volatility targeting, risk parity, CTAs and short volatility are facing outflows as volatility rises.

Third, macroeconomic fundamentals remain on the whole robust. The strength in activity data is broad-based, with US and European puchasing managers’ indices (PMIs) posting cyclical highs recently and EM GDP growth catching up with that in the developed world.

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