Justin Pawl, CFA, CAIA, CFP®
Last Week Today. After reports of patients’ blood clots, J&J halted the distribution of its Covid vaccine in the US and postponed the rollout in Europe. | Cryptocurrency trading platform Coinbase went public with its valuation briefly touching $100B, the meaning of “money” changing before our eyes. | President Biden announced sanctions against Russia for 2020 election interference, a large cyber attack on US gov’t and corporate networks, illegal annexation and occupation of Ukraine’s Crimea, and human rights abuses. | Pfizer announced it would ramp up production and deliver 10% more doses than anticipated by the end of May. While this is excellent news for the developed world, it will have less impact on developing markets as the storage requirements for Pfizer (and Moderna) vaccines are more stringent than that of the J&J vaccine, slowing progress toward worldwide herd immunity.
Despite a “surge” in inflation (see En Fuego, below), US Treasury yields traded lower on the week suggesting bond investors view sustained inflation as low risk. The economy hasn’t produced inflation sustainably above 2% since the 1990s, and bond traders don’t currently believe this time will be any different once the transitory effects of stimulus wear off. Meanwhile, equity markets continued to grind higher due to a combination of lower interest rates, robust economic data, and solid Q1 earnings announcements. The S&P 500 closed the week at a new high of 4,185.5. For detailed market performance, please click here Covenant Asset Class Performance Summary.
Volatility. Last week the VIX Index fell to its lowest level since the pandemic started, and the S&P 500 achieved a new record level. Two more milestones in the financial markets’ remarkable Covid recovery. The chart below provides context for the record in a rather novel fashion by comparing S&P 500 record highs since the early 1990s to the VIX Index (a measure of S&P 500 volatility). The horizontal axis represents S&P 500 trading levels. It resembles a typical chronological axis because once a new record is hit, the next one will necessarily occur at a later date. However, because the x-axis measures levels on the S&P 500, the scale does not reflect even time increments. The vertical y-axis is easier to explain, as it shows the level of the VIX Index at the time of each S&P 500 record. Hence, each dot on the chart is an S&P 500 record and the corresponding VIX Index level.
Source: Goldman Sachs Derivatives Research
This chart nicely highlights that while some new market highs are made when volatility is above 20, most stock market records occur when the VIX Index is below 20. Intuitively, the natural relationship of low expected volatility and record stock market levels makes sense. After all, if investors expect greater volatility ahead, they are less likely to pay higher prices for stocks today.
But clearly, it’s not impossible. The pandemic era is packed with new S&P 500 highs while the VIX is index was well above 20. Yet, recently, new highs are accompanied by a steeply declining VIX (highlighted in orange). Goldman Sachs points out that the recent change in the trend toward lower volatility and higher equity markets resembles 1997 and 1998 (the early stages of the Dot-com Bubble). In each of those years, major market events (e.g., S&P 500 reaching 1,000) led to a period of declining volatility, but markets became much more volatile shortly after that.
Another interpretation of the chart is that we’re in a period similar to 1999/2000. In 1999, new highs were met with rising volatility, partially out of concern for “Y2K”. Volatility declined when Y2K proved to be a non-issue, and the market continued to set new records until the Dot.com Bubble burst in March 2000. After dropping by ~50%, the S&P 500 did not make another new high until 2007. Less than 12 months after fully recovering from the Dot-com era, the Mortgage Crisis torpedoed the market again, preventing the S&P from making new highs until 2013. This series of volatility earthquakes and market setbacks created a lost decade for US stocks. This period shows up as the close horizontal distance between the new S&P 500 highs of 2000 and 2013 in the chart.
Studying the history of markets is essential, even though events and eras are never carbon copies. By studying history, one can understand what markets are capable of and plan accordingly. In the long history of markets, the last 12 years represent an anomaly as every market selloff was followed by a V-shaped recovery, the so-called “bear market” of 2020 lasted only six months, and never before have markets experienced such an extended period of ultra-low volatility. On this last point, take another look at the chart. New S&P 500 records with the VIX below 15 only occurred for about 2-3 years between 1993 and 1996. More recently, there were nearly ten years of S&P 500 records set with the VIX below 15. Many of those new highs came when the VIX was close to 10.
Of course, the last ten years coincide with widespread Quantitative Easing by the Fed and other central banks worldwide. Have central bankers figured out a way to permanently reduce volatility? Improbable. Financial markets are larger than central banks, and size matters. Indeed, future market historians will probably look back at the 2010 – 2020 period as a remarkable period of quiescence for a system that naturally operates with higher variability.
What does this say about the future? It seems unlikely that with the amount of central bank and government stimulus coursing through the global economy, stocks will suffer a significant decline in the near term. This view, of course, assumes the virus behaves, that vaccination distributions continue to accelerate, and they remain effective against Covid’s many mutations. However, it does seem that the level of uncertainty is higher than is warranted by the VIX Index trading at ~17. After a relatively smooth 11% gain in 3.5 months, we’re expecting a bumpier ride ahead for the S&P 500 and other financial assets.
En Fuego. Economic data released last week highlights that the US economy is emerging from the fog of Covid. We’re not all the way there yet…not by a long shot. But the economy is revving up as more people get back to work, social restrictions are eased, and the impacts from the most recent round of stimulus are beginning to make their way into the system. Highlights from last week include:
- As expected, inflation jumped in March. The headline CPI increased 2.6% year-over-year, while the Core CPI rose 1.6% (excluding food and energy prices). Headline inflation will likely remain over 2% for the next few months as base effects from collapsing price one year ago bias headline inflation higher.
- Retail sales surged 9.8% in March, well above the consensus estimate of 5.8%. The consumer is alive and well in the US, and while the monthly percentage increase is impressive, the following chart better illustrates the magnitude of consumption. The red line depicts trend retail sales growth before the pandemic. March’s expenditures were 17.1% higher than before the pandemic in February 2020 and 50% above their 2020 Lockdown low.
Source: FHN Financial
- Residential housing starts (1.739 million) rose a surprising 19.4% in March, more than 100,000 above consensus estimates on a Seasonally Adjusted Annual Rate (SAAR). Single-family residential homes continue to outpace multifamily starts, reflecting consumer preferences for private spaces since the beginning of the pandemic.
Source: FHN Financial