The sell-off that has hit stock markets in recent days appears to be little more than a correction – albeit a painful one – that should be welcomed, according to several investment commentators. 
After 2017 ended up being a fairly strong one for most markets – with the notable exception being the UK – the new year got off to a rockier start with surging performance at the start of January giving way to a broad-based sell-off by the end of the month.
The sell-off was sparked by growing concerns around inflation and the risk that interest rates will have to rise faster than expected, which initially started a rout in fixed income markets before spreading to stocks. US 10-year government bonds are now trading at 2.75 per cent.
Last Friday was a bad one for stock markets and the blame for this was laid at the door of US employment data, which showed that jobs continue to be created in US, the unemployment rate is very low and skills’ shortages are causing some wages to go up. All of these added to inflation concerns.
Performance of indices since 1 Jan 2018
Source: FE Analytics
FE Analytics shows that most stock markets made steady progress in the opening weeks of the year before coming off their highs from 26 January. The S&P 500, for example, has shed 7.7 per cent since this date while the FTSE All Share is down more than 4.5 per cent year-to-date – with yesterday being one of the worst sessions of the recent past.
Jim Wood-Smith, head of research at Hawksmoor Investment Management, is one investor who views the recent correction as being quite natural – even desirable – given how far markets have advanced and their need to factor in an environment of tighter monetary policy.
He noted that the S&P 500 has not posted a negative month for 15 months, was trading 13 per cent above its 200-day moving average and was sitting on a ‘relative strength indicator’ of around 87, suggesting all should have been cause for concern.
“This was technically the most ‘overbought’ American equities had been in the past 30 years. My argument is that American equities have been riding for a fall. Friday was overdue, natural and healthy,” Wood-Smith said.
“Having looked at a little of the devil in the detail, it is worth a quick existential reflection. Why is it that we see 15 consecutive monthly rises in equities as a bad thing? Why is it that rising markets make us queasy? Should we not all just be happy that clients have been making money for so long?
“It is, like so much of modern life, all about sustainability. Past returns and equity valuations are not sustainable. The more markets rise, the more painful the return to normality will be.”
With volatility falling to near-record lows in 2017, many investment experts have warned that this will not continue forever. As the chart below shows, January saw a large uptick in volatility and February, which is not captured in the data, has been even tougher.
Edward Park, investment director at Brooks Macdonald, is another who argued that the equity market sell-off is “a healthy correction, not a bear market”.
3-month volatility of S&P 500
Source: FE Analytics
Park noted that the outlook for bond markets looks “rocky” this year, as the Federal Reserve is looking to shrink its balance sheet at the same time as the European Central Bank has suggested bringing its quantitative easing programme to an end.
With these factors already worrying the equity market, higher than expected US hourly earnings data released on Friday made investors fret about a possible shift in the low inflation backdrop.
“We would caution one data point does not suggest that a trend has been created but equally with expectations of US inflation so low, the risk is to the upside over the course of 2018 particularly with the tax cut boost that will filter through the economy this year,” he added.
“Many sentiment and technical indicators were suggesting that the market was overbought in late January so part of this sell-off can be attributed more to technical factors than fundamental factors.”
Adrian Lowcock, investment director at Architas, agreed that after such an extended period of low volatility, a sell-off was in some ways overdue. However, he added that there are still many positives to be seen, with the economic outlook still positive and companies starting to boost capital expenditure.
“Investors need to keep perspective, markets don’t go up in a straight line and falls of 5 per cent to 10 per cent are not as uncommon as the last 18 months may have led some to believe,” Lowcock added.
“Focus on your own goals and not the short-term performance of markets, a sell-off of this magnitude was long overdue. Use the opportunity to ensure you have a diversified portfolio which is well positioned to protect against the volatility of markets.”
For investors looking to add downside protection to their portfolios, he highlighted three funds as potentially attractive holdings: JPM Global Macro Opportunities, which aims to identify and exploit global macro trends; Old Mutual Global Equity Absolute Return, which exploits investors’ behavioural biases and style drifts; and BlackRock Gold & General, which focuses on a sector that tends to perform strongly at times of market stress.
However, the sanguine comments about the sell-off do not necessarily mean that the rout will end immediately and markets return to the calmer conditions of the recent past.
Alex Scott, chief strategist at Seven Investment Management, said investors “have been living through extraordinary times for markets”, as 2017 witnessed the lowest levels of equity market volatility in a generation.
“In January, investors were contemplating a market ‘melt-up’, as US stocks enjoyed their best start to the year in over two decades and reached their longest ever period without a 5 per cent correction, topping 400 days. How quickly investor sentiment can change,” he concluded.
“This episode of market volatility has not yet played out and could well involve more wrenching trading sessions for investors. Central banks are gradually moving towards a more normal interest rate policy, and this will see some of the distortions of the last few years unwinding – not always smoothly.
“But the economic cycle has not yet turned, the growth outlook remains healthy, and this suggests that we face a market correction, not a sustained downturn or a recession.”