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Economic Insights

Historically, when the market experiences a volatility spike against the backdrop of a strong economy, equities and credit-sensitive fixed income tend to regain their footing relatively quickly.

Following are a few observations about events in the equity markets and markets more broadly over the past few days, particularly with regard to market volatility.  

Macroeconomic Perspective

Thus far, evidence suggests that the recent equity market volatility is an isolated event related to activity in the equity VIX market—that is, the market for volatility derivatives in the S&P 500® Index.  It has not been a response to a sudden rise in fundamental risk.

We make this observation for three reasons:

First, there are no indications of an economic slowdown. If anything, recent economic data have exceeded expectations more than usual. Among the U.S. economic data released this week (February 5, 2018), for example, was the January 2018 Non-Manufacturing ISM® "Report on Business," representing economic activity in the construction, retail, and services sectors. The non-manufacturing ISM reached 59.9%, a post–financial crisis high and a level that historically has been transcended only rarely. 

Second, inflation expectations remain stable, which suggests that the rise in yields that we’ve seen recently could be limited. The U.S. Bureau of Labor Statistics’ Employment Cost Index (thought by economists to be the most robust labor-cost data released by any of the statistical agencies) shows that total compensation costs have been accelerating very slowly—although, in our opinion, not nearly fast enough to kindle worries about incipient inflation. Moreover, accelerating U.S. labor productivity growth (which has been on an improving trend since 2016) is likely to mitigate any negative effects of rising wages—if wages were ever to rise noticeably—on inflation. 

Third, corporate earnings have been coming in very strong (something we will later discuss).

U.S. Fixed Income

In the fixed-income markets, credit spreads have remained quite stable. Investment-grade spreads, for example, essentially were unchanged during the period the equity markets were falling, and they’re still tighter year to date (as of February 6, 2018). Meanwhile, although high-yield spreads widened modestly during the recent market turmoil, they too are still tighter since January 1, 2018. Considering what has been going on in equities, the high-yield market has been behaving quite well. 

Historically, when we’ve seen volatility spikes like the recent one, investment-grade and high-yield spreads typically have, six or 12 months later, tightened somewhat, though the path to that tightening can be bumpy.  

We also think it is important to note that the high-yield market has become a higher-quality market over time. That may be one of the reasons why high yield seems to be performing better than we might have expected, based on history and the current environment. Over the past 10 years, ‘BB’ rated credits have gone from 38% of the high-yield market to 47% at the end of 2017, while credits rated ‘CCC’ and below now represent just 15% of the market, down from 19% over the same time period. So, the overall credit quality of the high-yield market has improved. 

U.S. Equities

In equities
, the backdrop remains supportive, because equity fundamentals are very strong. For example, of the 250 companies in the S&P 500 Index that have reported earnings (as of February 2, 2018) for the fourth quarter of 2017, 76% have beaten earnings estimates and 79% have exceeded sales expectations. Those ratios typically are in the low 60s, so companies are healthy and beating expectations by much more than they usually do. Moreover, among those reporting companies, earnings per share is up 12.4% in the fourth quarter of 2017 (as of December 31, 2017), compared with the year-ago quarter, and sales are up more than 10% over the same time period. Those are extraordinary results.

Historical Perspective

When we look at drawdowns of this sort historically, equities, on average, are typically higher three, six, or 12 months down the road. They’re especially higher, and more consistently so, after a sell-off that takes place during a strong economy, such as the one today. For example, historically, the S&P 500 is typically 10% higher 12 months after a drawdown of the magnitude witnessed in recent days.

We believe, therefore, it is important to maintain perspective. Historically, when the market experiences a volatility spike against the backdrop of a strong economy—regardless of the catalyst—stocks and credit tend to regain their footing relatively quickly. 

Our message to investors: Stay resolved—and, colloquially speaking, hang in there.

 

Glossary of Terms

The employment cost index (ECI) is a quarterly economic series detailing the changes in the costs of labor for businesses in the United States economy. The ECI is prepared by the Bureau of Labor Statistics (BLS), in the U.S. Department of Labor.

The CBOE Volatility Index (VIX) is a popular measure of the stock market's expectation of volatility implied by S&P 500 index options, calculated and published by the Chicago Board Options Exchange (CBOE).

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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