During this period, market participants were reminded that the stock market and the economy are not the same thing. The US Labor Department’s January jobs report showed that 200,000 new jobs were added in the first month of 2018. Meanwhile, the historic rise in global equities came to an abrupt halt. An unprecedented streak of 19 consecutive months without a 5% correction was finally broken. Following the Labor Department’s report, which also showed that wage growth jumped 2.9% year-over-year, global benchmarks fell over 7% during the next six trading days. The fear that wage growth will lead to higher inflation, and higher inflation will lead to the US Federal Reserve raising rates more quickly resulted in the S&P 500 giving back all of 2018’s gains as it entered a correction. A correction, which is a 10% pullback from a market peak, occurred on 26-Jan-18. Market corrections typically occur every other year, on average. However, the last correction for the S&P 500 was almost two years ago. Interestingly, the correction occurred less than a week after investors poured record amounts into exchange-traded funds in January.
Despite raising rates five times since late 2015, developed-market sovereign bond yields have remained stubbornly low until recently. As inflation began showing up in US consumer reports, yields started its ascent. Adding fuel to the inflation narrative, US President Donald Trump unveiled his $1.7 trillion infrastructure spending plan that will take place over the next 10-years and the US dollar depreciated nearly 15% against a basket of its key trading partners. As a result, the 10-year US Treasury Yield hit 2.92%, a level it hasn’t reached in almost 3-years, which followed the original “taper tantrum” sell-off. More significant perhaps, the equity market correction was not accompanied by rising bond prices – bonds did not act as the “hedge” that many strategies and allocation models assume.
Over the course of the last few years, many investors have abandoned traditional hedging strategies as the cost of insurance made it difficult to outperform a constantly rising benchmark. Rather, many investors tried to exploit the rising trend by selling volatility or buying inverse volatility strategies through exchange traded funds/notes (XIV Index). As a result, participants were caught off-guard and on the opposite end of the violent unwind that ensued in February. The sell-off resulted in the largest single-day point drop (not largest percentage drop) for the Dow Jones Industrial Average and wiped out nearly six years’ worth of gains for the XIV Index. More concerning for long-term investors is the outcome for these rules-based or “smart-beta” strategies, which include styles like risk parity. These strategies incorporate volatility to define the allocation of capital to different assets and rely on liquidity. A dangerous feedback loop may arise as the underlying securities can’t provide the liquidity promised by the exchange traded notes/funds as investors stampede out of the strategies.