Biggest US stock market correction since 2011

06/02/2018

On February 5, US equities had their biggest correction since August 2011. We see the decline in the equity market primarily as a technical correction and not caused by a change in the underlying fundamentals.

The implied volatility witnessed its largest increase ever, moving from 17 (February 2) to 37 on February 5. Noteworthy was the fact that intraday, the US market lived through a mini-flash crash. This underscores the technical state of the correction. We closely monitor our technical market indicators. If these evolve further towards neutral or even into positive territory, we may consider increasing our exposure towards risky assets.

The US market lived through a mini-flash crash


Source: Thomson Reuters Datastream, NN Investment Partners

Technical correction in US equity

The sell-off was broad-based across sectors, although the utilities and real estate sectors were somewhat more resilient, helped by the 15bp drop in US 10-year government bonds. Although there were spillovers last night in the Asian market, there is no sense of panic in European equity markets this morning. The drop in Europe is less than 2% at the time of writing. There was no noteworthy impact on credit markets.

How can we explain this correction?

We think it is primarily a technical correction which was long due. Investor positioning in risky assets had risen to multi-year highs, as illustrated by the record inflows in January in equity funds and ETFs. Investor optimism was also high, illustrated by the low put/call ratio and the high bull/bear sentiment index earlier in the year. In addition, there was a broad based consensus with regard to sectors (financials and cyclicals versus utilities and real estate), themes (short volatility) and asset classes (equities over bonds), which reversed yesterday. Our technical indicators, which indeed showed frothiness in the market for some time now and which led us to reduce our equity exposure early January, have been moving gradually towards more neutral levels over the past couple of days.

The fundamental picture has not changed

Corporate earnings are stronger than expected, even in the wake of some disappointment in energy sector earnings last Friday. 80% of US companies beat expectations and momentum for 2018 remains at high levels. Global earnings are expected to grow at a double-digit pace this year. On the macroeconomic side not much has changed either. Economic data are coming in strong and the surprise indicators even rose a bit yesterday.

Nevertheless, we can make two very general points here:

  • First, central banks are facing a fundamental tension between two issues. On the one hand, there is a need to make sure that inflation expectations become more firmly anchored to the target after a long period of low inflation rates. On the other hand, the relatively easy monetary policy stance required to achieve this may increase risks of overheating in the real economy as well as irrational exuberance in markets. Obviously, this tension is a recipe for more volatility down the road.
  • Second, lowflation risks are diminishing, albeit mostly so in the US. This naturally leads to more Fed confidence in its ability to bring rates back to neutral and more ECB confidence in its gradual steps towards the exit. The concomitant market repricing and move up in longer-term bond yields can sometimes get a bit ahead of itself and represent a headwind for risky assets. Having said that, the latter receive ample protection from synchronized and solid global growth. As long as the latter continues, we see little reason to expect this headwind to become permanent, especially because central banks will not react very strongly to an upturn in inflation momentum. In this sense, our central bank thinking has not changed. We still expect three US rate hikes this year and a soft taper by the ECB after September.

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    About the author

    Valentijn van Nieuwenhuijzen

    Valentijn van Nieuwenhuijzen

    Chief Investment Officer of NN Investment Partners

    Experience since 1998

    About the author

    Patrick Moonen

    Patrick Moonen

    Head of Macro & Strategy (Multi-Asset)

    Experience since 1989