The recent upswing in equity volatility can be attributed largely to concerns about the future direction of Federal Reserve policy. Markets could remain volatile as investors adjust to greater uncertainty about U.S. inflation and interest rates. However, economic and earnings fundamentals continue to be supportive for equity valuations.
Following a powerful rally that lifted the S&P 500 Index almost 22% in 2017, U.S. stock prices have fallen sharply in recent days, ending—or at least interrupting—a lengthy period of unusually low market volatility. The selling pressure quickly spread to other global equity markets, producing similarly abrupt price declines.
To a certain extent, a short-term correction in U.S. and global equity prices could be viewed as overdue, given the strength and speed of the market gains last year and in the opening month of 2018. The immediate trigger for the downturn appears to have been a spike in U.S. long-term Treasury yields, which accelerated in January as fixed income investors became more wary of the outlook for U.S. economic growth and inflation.
Rising Treasury yields can translate into higher borrowing costs, such as interest rates on mortgage loans. Higher borrowing costs, in turn, could discourage consumers and businesses from borrowing to make purchases and investments and slow the economy. Rising wages and other input costs eventually could start to weigh on corporate margins. Higher yields can also make bonds relatively more attractive than stocks.
Some perspective on the recent market volatility is warranted. First, corporate fundamentals and the global economy appear strong. Second, T. Rowe Price economists believe the Fed remains on a gradual tightening path. Third, it’s important for investors to keep short-term market volatility in perspective when compared with long-term market results.
Equity Fundamentals Still Appear Strong
Equity markets could remain unstable in the coming days as investors adjust to the return of volatility and greater uncertainty about the course of U.S. inflation and interest rates. Technical factors, such as program trading activity tied to the Chicago Board Options Exchange’s Volatility Index (the VIX), could also drive large intraday market movements, both up and down.
However, while short-term trends in the stock market are almost impossible to forecast, economic and earnings fundamentals continue to be supportive for equity valuations, in our view:
- Global economies are in a synchronized expansion.
- The backdrop for corporate earnings, which have been growing at a double-digit pace in the U.S. and other important markets, is favorable.
- Interest rates and inflation are still relatively low in developed countries.
- Recently passed U.S. tax reform legislation is likely to lead to a pickup in domestic economic growth and even stronger corporate profits in 2018.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of February 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
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