Andrew Pyle
December 03, 2021
A Variant of Correction
A couple of weeks back, I commented that with the third quarter earnings season behind us, financial markets would be wandering into an information vacuum – one that could easily be filled by headline shocks. That could come from covid, worries over inflation and interest rates, or even a geopolitical jolt. As it turns out, investors had to contend with the first two in rapid succession.
The first hit came the day after US Thanksgiving when it was revealed that a new variant had been identified in a number of south African countries, named Omicron. Stocks tumbled last Friday, but revived on Monday, only to be knocked back down on Tuesday as Fed Chairman J. Powell donned a hawkish guise. His remarks that the term “transitory” needs to be retired when referencing the recent spike in inflation and that quantitative easing might need to come to a more rapid end reinforced a fear tht interest rates were about to start climbing. There was a short-lived bounce Wednesday morning, but conviction faded, and equities took another dive. No sooner had the closing bell rung and stock futures started rallying and buying continued through Thursday.
The rollercoaster ride that has emerged at the start of December is a subtle reminder to what I would refer to as a complacent market, that there is risk in stocks. As of Thursday’s close, the S&P500 had gone up or down by more than 1% each day for five consecutive days – the longest streak since the first week of November 2020. That week, if you recall, came at the end of just over a two-week 7.5% drop in the index negative month for trading in September.
The daily moves are reflected in a jump in the Chicago Board Options Exchange Volatility Index, or VIX. This week we broke above 30 since early February – a time when volatility was a little exaggerated, considering the relatively gentle 3.5% slip in the S&P. There hasn’t been a lot of talk of this, but this week’s spike in the VIX ends a pattern of lower highs that we have seen since the start of the pandemic. That doesn’t necessarily mean we are entering a new pattern of upwardly trending volatility; however, the technical signals might be enough to halt the complacency.
The difference between today and November of last year is that this latest string of swings is taking place after a relatively strong November. In fact, technicians will argue that the variant and hawkish inflation undertones at the Fed were simply matches tossed into a barrel of gasoline created by repeated failure by the S&P to sustain moves above 4700.
The VIX isn’t the only thing comparable to the start of the year. This week, the 30 yr US Treasury bond yield fell below 1.8% for the first time since late-January. When you consider the fact that the head of the Federal Reserve just told the world that inflation looks to be stickier than originally thought and that the Fed would be out of the bond buying game possibly by the end of the first quarter next year, you would think that bond yields would be heading in the opposite direction.
My analogy over the years has been that if stock traders are the ones dancing on barstools at the pub, bond traders are the designated drivers. A solemn bunch they are as they typically only get excited when an economy is about to fall backwards. To be sure, there is plenty to make the bond market happy. There is a new covid variant that is going to dominate the headlines for at least a couple of weeks until doctors and scientists figure out the level of severity. Then there is the prospect for earlier and more rapid monetary stimulus withdrawal. Given the huge amount of debt the world has amassed during this pandemic, any significant jump in rates will cool economic growth, on top of the braking effect of supply bottlenecks.
The problem is that the bond market might be just a little too gloomy for its own good. If the variant proves to be a minor hinderance, or no hinderance at all to economic activity, then we would expect the recovery to continue to build. Yes, the Federal Reserve will likely taper from its bond buying program faster; but let’s not mistake reduced stimulus with tightening. Even when official rates start to nudge higher, we are starting effectively at zero. Four rate hikes next year only gets us to 1%. It’s sort of like the spin classes I do in the basement in the morning (thank-you Apple Fitness). You start with a nice and easy warm-up, then start to tighten the resistance to medium. You can feel it, but you can keep riding for an hour without getting tired. Its’ only when you turn the resistance to hard that you know you are having a workout. That probably starts to show in 2023 when the official rates for the Fed and Bank of Canada get above 2%.
Once short-term rates begin to climb it will be difficult for long-term bond yields to stay low without strong evidence that the economy is faltering. Therefore, I would view this recent slide in long yields as perhaps the last hurrah for somber government bond market this cycle. In less than two weeks, we will get the next Federal Reserve FOMC meeting, and I imagine there will be a greater focus on clarity (i.e., no boat rocking) and we should also have clarity around the new variant, good or bad.
This morning’s US jobs report delivered a weaker-than-expected 210K rise in non-farm payrolls, but the household survey showed a massive 1.136 million and this sent the unemployment rate down to 4.2%. A few points to make here. First, the survey time-period was as of November 13th – in other words, before Omicron was revealed. The drop in the unemployment rate is completely consistent with the fact that initial jobless claims hit the lowest levels since 1969. Finally, the gap between the weak payrolls number and household employment could indicate a shift by workers away from the pre-pandemic jobs to setting up their own businesses. Bottom line, the employment report just added uncertainty to the mix.
This recent spate of higher volatility in stocks and the net decline in valuations over the past week are healthy reminders that risk needs to be priced appropriately. We are overdue for a 10% pullback in the general market and, if we were to experience one now, the S&P gets deflated all the way back to levels seen in the third week of June. My opinion is that with quantitative easing still net positive for the market and the economy moving forward, there is a low probability of this happening soon. Still, this recent pullback has offered up an opportunity in an otherwise upward trending market. The situation still argues, however, for a modest stockpile of cash in case we do get a larger retracement, as that will be a solid buying occasion.