T. Rowe Price T. Rowe Price Trusty Logo

Blog

Have The Bears Eaten Goldilocks?

David J. Eiswert, Portfolio Manager, Global Focused Growth Equity Strategy

While regime change is an absolute certainty when considering the evolution of economic and equity cycles, the rise in volatility and fall in global equity markets in February has shown once again how much equity markets tend to react in the short term to points of change. In this case, with a decent sized tantrum.

The somewhat unusual trigger for the biggest single-day point loss for the Dow Jones Industrial Index in history was centered on a positive upside surprise for U.S. wage data. While you might think that indicators of the real economy getting better might be viewed as positive, clearly the prospect of inflation rising—temporarily or more sustainably—got the market thinking more about life after QE and maybe life in a higher interest rate world. One way or another, change has once again shown itself to be a lot less loved than presumed certainty.

Given that equity investors enjoyed an unusually stable and profitable period in 2017, change and evolution was always likely, with selling pressure the most obvious outcome. This is especially true with bears having sharpened their claws on the back of an almost 25% return for global equity markets in 2017.1 This has, of course, come on top of the monumental returns over the past nine years (Figure 1).

FIGURE 1: The Unloved Global Equity Rally

Regional Returns, as of December 31, 2017.

Sources: MSCI and FactSet.
Note: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
Past performance cannot guarantee future results.

What are our observations on the market correction? The catalyst, while fundamental in origin, felt quite technical in execution. To reiterate our view, we believe that the economic backdrop remains largely stable to improving and that equity valuations remain reasonable, given a solid corporate earnings outlook. Pretty undramatic stuff.

However, we have felt investor sentiment rising a long way over the past year. Given this, the market adjusting to new data around inflation “risk,” via a rise in the Chicago Board Options Exchange Volatility Index (the VIX), and a pull-back in markets is intuitively quite “normal.” Perhaps less normal was the speed and magnitude with which capital withdrew from markets, as a rising VIX index seemed to shock volatility-linked products into selling and rebalancing.

While no one knows the true extent to which market ownership has changed over the past few years, February’s pullback gives some indication that portfolio insurance and target volatility products are meaningful market movers in a way that was not the case in decades past. This perhaps indicates that while volatility has been low, inflection points will be harsh. With the last meaningful risk off environment nearly two years ago (China and oil), so it proved to be the case as the rush for the exit door unfolded in February.

The saving grace for investors is that despite the sharp falls, the pullback has only eliminated one month’s gains (January’s 5% return2, in effect), while sentiment and markets have steadied in March. In addition, the volatility shock has somewhat pushed away the risk that markets have been flirting with excessive optimism or even mild euphoria and reminded us all that equity investing and volatility naturally go hand in hand.

Opening Quote We reiterate our view that the economic backdrop remains largely stable to improving and that equity valuations are reasonable, given a solid corporate earnings outlook. Closing Quote

Why do we remain sanguine?

While we can see that an inflation impulse is playing out year-on-year from a low base level in Q1 2017 (when many companies and consumers were grappling with what U.S. political regime change meant for them), we remain relatively skeptical that inflation will meaningfully and persistently rise, ushering in a new market regime of considerably higher interest rates. Our expectations for how much inflation may change from today’s muted levels have their roots in structural deflationary forces that exist today. The secular impact of technology, globalization, and demographics upon inflation remain headwinds for a sustained rise in inflation. While these factors do not sit comfortably in economists’ models and are hard to measure, these influences are real and have been showing themselves in inflation data that should, all being equal, already be much higher.

So why is the market so concerned? We talked about this back in August of last year in the article, “Inflation Surprise? Don’t Fear the Reaper!” In that article, we identified that tightening U.S. employment may be the indicator to look out for as the potential trigger for higher interest rates and investor concern, and so it proved (Figure 2). While the U.S. Federal Reserve has started to talk much tougher around the upside risks to inflation, we still believe that, all else being equal, the deflationary factors will mute the rise in prices over the next phase of this cycle versus previous economic cycles.

While we remain open to change, we currently sense very little appetite from corporates to embark on a sustained rise in wages. Given this and despite a portion of tax cut benefits being passed onto employees in the near term, the inflation cycle still looks modest to us. February’s volatility spike, however, is a reminder that a slow shift in regime is key to market stability, as it will give markets, corporates, and consumers time to adjust as interest rates begin to gradually rise.

FIGURE 2: U.S. Inflation Concerns Causing a Spike in Treasury Yields

U.S. Treasury Yields, December 31, 2002–February 28, 2018

Source: FactSet.

Do the bears have a feast ahead?

If we are wrong, a rise in inflation and tighter monetary policy could certainly be a risk to the not too hot, not too cold “goldilocks” market environment, but one month’s data does not a trend make. We are likely to have a bumpier ride ahead, as a greater breadth of sentiment emerges on less universally positive data points. While challenging for investors who want to allocate capital to themes associated with obvious improvement, some injection of uncertainty feels normal as well as healthy. This is especially true for us as fundamental stock pickers who now get a chance to improve portfolios on weakness.

We will continue to use any form of volatility and market decline to refresh our portfolio, and that is exactly what we have been doing in recent weeks. It has allowed us to top-up on our favored positions but also add exposure to stocks that we had judged to have been on the more expensive side. We now sit with a portfolio of stocks that we believe are well positioned, even in a potentially more volatile environment.

Key Risks: Transactions in securities of foreign currencies may be subject to fluctuations of exchange rates, which may affect the value of an investment. The strategy is subject to the volatility inherent in equity investing, and its value may fluctuate more than a fund investing in income-oriented securities. The strategy may include investments in the securities of companies listed on the stock exchanges of developing countries.

1 MSCI All Country World Index +24.62% for the 1 year period ended December 31, 2017. [Return to Text]

2 As measured by the MSCI All Country World Index. [Return to Text]

Important Information
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc. © 2018 T. Rowe Price. All rights reserved.

201803-451363

Dismiss
Tap to dismiss

Download

Latest Date Range
Audience for the document: Share Class: Language of the document:
Download Cancel

Download

Share Class: Language of the document:
Download Cancel
Sign in to manage subscriptions for products, insights and email updates.
Continue with sign in?
To complete sign in and be redirected to your registered country, please select continue. Select cancel to remain on the current site.
Continue Cancel
Once registered, you'll be able to start subscribing.

Change Details

If you need to change your email address please contact us.
Subscriptions
OK
You are ready to start subscribing.
Get started by going to our products or insights section to follow what you're interested in.

Products Insights

GIPS® Information

T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®). TRP has been independently verified for the twenty one- year period ended June 30, 2017 by KPMG LLP. The verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

TRP is a U.S. investment management firm with various investment advisers registered with the U.S. Securities and Exchange Commission, the U.K. Financial Conduct Authority, and other regulatory bodies in various countries and holds itself out as such to potential clients for GIPS purposes. TRP further defines itself under GIPS as a discretionary investment manager providing services primarily to institutional clients with regard to various mandates, which include U.S, international, and global strategies but excluding the services of the Private Asset Management group.

A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

Other Literature

You have successfully subscribed.

Notify me by email when
regular data and commentary is available
exceptional commentary is available
new articles become available

Thank you for your continued interest