This past week was a wake-up call for those who may have fallen asleep during the boring and low-volatility rally in US equities last year. Given that the rise in the S&P500 during the first three weeks of January exceeded three of the four quarterly gains last year, one could be excused for being a little jolted by the worst back-to-back losses since last May. While things look a little calmer, are there signs of more damage to come?
Predicting where stocks were going to head in the coming week, let alone the coming year, is a mugs game at best. Bulls hang on to their tax reform and animal spirit arguments, while bears cite late-cycle risks and Washington. The easier forecast was simply that volatility in the market was likely to increase in 2018 and, so far, that is holding true. The Chicago Options Board Volatility Index, or VIX, had reached a record low 9.1 in the first week of January, but has spiked to almost 15 this week. We saw a similar move back in August, but this one may have ruffled feathers a little more. Ditto if volatility holds here or rises.
Of course, as with many market setbacks there wasn’t a fundamental factor to explain the erosion in valuations from last Friday. Rather, it was a confluence of a number of developments. This would include the fact that longer-term bond yields have risen further, with the 30yr US government bond breaking above 3% for the first time since May. Health care stocks also came under attack in the wake of the joint announcement by Amazon, Berkshire Hathaway and JPMorgan that they would create an entity to make health care more affordable. Most US economic indicators were positive this week, but the Federal Reserve re-affirmed its plan to raising rates in March. That doesn’t mean all is pristine on the economic front.
No matter what someone tells you about how lower corporate taxes are going to springboard the US economy into a 4, 5 or 6 per cent world, because of increased investment spending; the reality is that the consumer still dominates. Yes, metrics like employment, incomes and confidence suggest American households still have the ability to fuel growth for a few more quarters at least. The stock market isn’t exactly buying it though, at least in terms of how it views the two main big-ticket areas of housing and autos.
As you can see from the following chart, the correction in both these segments of the market began before this week’s general market sell-off. Autos staged a significant correction after topping out on January 12th. As of Thursday’s close it had fallen 10%. Note, this is one of the few sectors that hasn’t recently hit a new record high and probably never will for the foreseeable future. Homebuilder stocks reached their peak on January 22nd (the highest in 12 years), before falling back. In less than two weeks, this group has also fallen 10%. In the case of both segments, there have been signs of consumer fatigue; like weaker home and vehicle sales.
Some of this can be attributed to weather, while we may also be looking at the end of the spending boost coming out of last year’s devastating hurricanes. Still, markets are typically good at looking through such noise, so there must be something else that is troubling the equity participants. One item would be the escalation in borrowing costs as bond yields rise. This week, the 30yr US mortgage rate rose above 4.4% for the first time since last March and now less than half a percent from the peak we saw in 2013.
Higher borrowing costs are also a concern in the auto sector where we have already seen consumers stretch out car payments and take on heftier loans. Defaults have started to edge higher, though this hasn’t deterred investors from rushing in to buy sub-prime auto loans. According to Bloomberg, $25 billion of auto sub-prime loans were packaged into bonds and sold last year. This compares to about $400 billion of sub-prime mortgages in 2006, just before the crisis. Therefore, this isn’t a development that will create a 2008-style plunge in stocks; but it is something that can sap the general euphoria in stocks that we have seen, and it can definitely keep volatility levels elevated.
Canada: Merchandise trade, Ivey PMI, building permits, housing starts, new home prices, employment
US: ISM manufacturing, Q4 mortgage delinquencies, trade, consumer credit, wholesale inventories
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