Fra BNP Paribas:
We see the stock correction as resulting from higher bond yields which have followed from increased estimates of Fed hikes, in turn driven by raised inflation expectations.
Higher volatility was magnified by hits taken to short volatility positions. A calmer period
could lie ahead but the illusion of low volatility forever is smashed.
Valuations still remain expensive for many assets and central bank support for prices is
diminishing. Recent moves may have been a ‘taster” for future market evolution.
Markets are starting to believe in inflation more, so “good” growth news may be “bad”.
But not as bad as strong inflation prints. Watch the US core CPI next week. Stock prices have taken a beating. How much does this matter for the economy and the Fed? The answer depends on why the correction happened and if it continues. If we think about the macro economic factors underlying stock valuation, there are a number of possible causes of a valuation shift:
1) Changes in assessments of future GDP growth;
2) Changes in the expected share of profits in GDP;
3) Changes in the expected risk-free discount rate applied to future profits growth;
4) Changes in the risk premium required to induce investors to hold stocks over bonds.
In terms of GDP, while Q4 growth was a bit below expectations, domestic demand was extremely robust. Non-manufacturing ISM this week reached a 12-year high and the employment component was the strongest ever. It does not look to us that a downgrade of growth expectations driven by “news” on growth was behind the shock. Having said that, market views of Fed policy have shifted over recent months with upgraded growth and inflation forecasts provoking a reassessment of how far and how fast the Fed may raise rates.
We see the curve having flattened compared with say six months ago and the dollar refusing to be buoyed by Fed rate hikes, as suggestive of markets thinking that the chances have been increasing that policy may end the recovery. MIT economist Rudi Dornbusch once said, “None of the post-war expansions died of old age. They were all murdered by the Fed”.
Turning to profit share, the tax cut has improved the position of corporates – increasing the corporate share of GDP at the expense of government. However, the Employment Cost Index (ECI) for Q4 came in above expectations and last week’s average hourly earnings reached a cycle high of 2.9% y/y. Not only can this be seen as a possible harbinger of future inflation but higher wages are a potential threat to profits per unit of output. It may be that the market saw an increased risk of a lower future profit share.
Over recent weeks, the market has being pricing in an increased chance of the Fed actually delivering three rate hikes in 2018, the reason being very “solid” consumption, investment and labour markets (to quote the Fed) and the prospect of the Fed hitting its 2% core PCE target relatively soon once 2017 base effects drop out.
Early 2017 sequential downward surprises in inflation seem to have fizzled out and there has been some upside surprise in core inflation (eg, in December). Base effects suggest inflation will soon be close to the Fed’s target. With unemployment only half a point below the Fed’s estimate of equilibrium and fed funds still being only 1.25-1.50%, as against Fed’s estimate of long-run equilibrium at 2.75%, the Fed looks to be well behind the curve.
Break-evens have been rising on a global basis (Chart 1), which we see as important for the US in a globalised world. Bond yield movements in the US, especially at the short end of the curve, have largely been driven by upward revisions in estimates of where fed funds are going (Chart 2). Faster growth, challenges to the previous assumption that inflation was unlikely to increase and signs of wages picking up, we believe, have been important in challenging the complacency in the markets about low volatility lasting indefinitely. With central banks clearly on the exit path to reducing extraordinary accommodation, increased volatility was always likely at some stage.
Many seem to have been following the old Chuck Prince adage, “But as long as the music’s playing, you’ve got to get up and dance”, large positions had been built up in betting on continued low volatility (eg, in inverse-VIX products). When the vol spike correction came, capitulation on low-vol bets magnified the dynamics, giving some spectacular declines in stocks. With some low-vol equity positions having been wiped out, things seem calmer. But the belief in low volatility forever is holed below the water line and aftershocks are likely. At his stage, we are not predicting continued near-term substantial falls that might affect our macro-economic outlook. The losses over recent days have basically taken stocks back to the level at which they started the year. The rise in wealth in January is unlikely to have percolated through to consumption or investment much, so that the recent reverse should not have much effect.
Will the fall affect the Fed? It is almost certain to sit up and take notice but we’d be very surprised if recent developments would prompt it to reconsider its medium-term path for growth, unemployment and inflation, especially as it just revised up its overall growth assessment to “solid” across the board. Since it sets policy for the medium term, we doubt it will shift down its assessment of how many hikes may be needed this year. But the stock correction reduces the chances that in March it will show four “dots” this year instead of three.
If stocks fell say 15% or so further, then the Fed might start to get cold feet. This because, broadly speaking, we’d reckon that a 15% fall in stocks from here might raise the household savings ratio over time by 1pp or so. With tax cuts coming and the economy currently growing at a 3% clip, this would still leave us with growth of 2% or so, but the Fed might contemplate pausing. We are not complacent about the stock correction. Judged from the perspective of Shiller’s cyclically adjusted PE ratio, they are still very expensive and at some stage a larger correction could come.
In fact at some stage this seems likely. We have concerns that stocks are one symptom of a stretched valuations across a range of assets (crypto-currencies being another) that have been fed by very expansive global monetary policy. Since the tide is going out on this,
and policy is expected to ‘normalise’, further stresses may emerge. We will watch US corporate credit – only slightly wider compared with treasuries over recent days – closely as a leading indicator of US activity, for example, as well as profitability and the shape of the yield curve.
In terms of economic indicators, we are now at the stage of the cycle where good news is, at least potentially, bad news for stocks and bonds. In the immediate period ahead, we see
continued strong global activity. We also believe that the trend in inflation is up. The low point for US core PCE y/y inflation is likely to be February. By July we expect it to be at 2% y/y.
Next week’s CPI is very important. The market estimate of core CPI is 0.2% m/m. In recent months, figures have alternated on the strong and weak side of this. Last month’s number was strong, so a weak print might be expected. However, our forecast is another strong figure – close to 0.3% m/m. If delivered, that might further feed the higher rate expectations and hurt stocks.
