Inflection Point

Friday’s melt down by US equity markets capped off the worst weekly performance by all three major equity market indices in over a year. On Friday alone the S&P 500 lost 59.85 points or 2.12%. The Dow Industrials (-665.75 pts/2.54%) and Nasdaq Composite (144.94pts/-1.96%) traded lower in lockstep. Adding significance to the trade, volume expanded dramatically for the week and in particular on Friday. On Friday NYSE volume surged 8.89%. Nasdaq volume jumped 12.65%. The negative price action coupled with the massive uptick in volume underscores my sense that we have reached an inflection point of sorts. Additionally, markets closed on their intraday lows – rarely a good sign.

The primary driver of the selloff was a result of dramatically rising interest rates.

On Friday the closely watched US 10-yr yield rose 2.92% to close at 2.85%. Not only is that the highest yield for the 10-yr. over the past 12 months, it is it’s highest yield since January 6, 2014. That lurch higher in rates has altered the landscape for investors in a potentially meaningful way.

Including last week’s selloff, the S&P still has a relatively elevated P/E of 22.47 and a 52-week gain of 22.62%. It could be argued that as a result of stretched valuations alone, equity markets have been due for a pullback and ultimately a degree of valuation compression. I have made that argument here in the note, but that is not the whole story.

That valuation-centric premise has been buttressed by a dramatic shift higher in T-note yields – a move long anticipated but delayed by Federal Reserve monetary policy.

On Friday, the dramatic turn lower in equity prices coupled with the equally dramatic rise in interest rates was captured by the long-dormant Volatility Index (VIX). On the day, the VIX sharply rose 28.52% to close the session at 17.31 – the highest close since October 31, 2016.

We have finally reached an inflection point in markets. The long-awaited confluence of rising interest rates, fueled by improving inflation metrics found in employment and other economic data, has fueled active hedging on the part of portfolio managers. Traders are expecting the recent turn higher in rates to materialize as a trend. By historical standards, interest rates are still relatively low, and if forecasts for increased economic activity, continued gains in employment, expanding GDP and improving corporate results are any indication, they could potentially rise meaningfully higher in coming quarters.

FOMC update

In the first FOMC meeting of the year last week, the Fed left rates unchanged, as expected, but did lay the groundwork for further tightening in 2018. That guidance on Wednesday in conjunction with the Atlanta Fed’s call for a Q1 GDP reading of 5.4% on Thursday fueled a shift in investor expectations that lulled even the most hesitant bond bulls to reverse course – putting an exclamation point on the thesis that the 30-year bull market in US Treasuries has come to an end.

Last week’s turbulence in US equity and credit markets did to a degree also spill over into energy markets. US WTI crude prices moderated during the week.

From Friday, January 26 through last Friday, February 2, WTI slipped 1%. Though I do expect continued expansion of US shale oil production to impact energy prices in the form of a headwind, consumption will remain strong. Weakness in the US dollar should act as a counterbalance to that theme (see Sam Stovall’s mention of the weakness in the US dollar).

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