OCEAN CITY — The current stock market selloff has spurred flashbacks for previous financial crises, with the S&P 500 down roughly 11% from its May peak. These concerns have been stoked by slowing growth in China, a steep decline in commodity prices, a strengthening U.S. dollar and a potential rate hike by the Federal Reserve (Fed).
While investor uncertainty remains elevated, pullbacks of 5% or more happen more than three times a year on average, and this is only the third since the Taper Tantrum of 2013. Given that the S&P 500 has fallen below several key technical levels and momentum stocks have broken down, equities remain vulnerable in the near term.
One of the points of vulnerability comes from the U.S. high yield market. Investors have pointed to the recent underperformance of high yield as a warning sign for equities, as these asset classes have historically moved in tandem. The growing disconnect between the two has raised concerns that the current stock market selloff is the beginning of a more prolonged downturn. However, the positive fundamentals of improving economic growth and accommodative monetary policies in developed markets remain intact, supporting equities over bonds.
We therefore advise investors to remain patient, and view this volatility as an opportunity to rebalance portfolios in line with long-term financial goals.
Volatility has picked up as investors seem to be growing increasingly concerned that the recent decline in the Chinese yuan and collapse in Emerging Market currencies in general are signaling a global growth slump. However, our view is that China’s currency move was designed to support growth by boosting its competitiveness in the global marketplace and increase its exchange rate flexibility in the long run. While slowing activity in China is certainly weighing on theglobal growth outlook, the resulting decline in commodity prices is ultimately a positive for net importers such as the U.S., Europe and Japan, and consumer spending in general.
The steep decline in commodity prices has been another drag on both equities and bonds, with Energy and Materials the worst-performing sectors in the S&P 500 this year. We expect commodity prices to remain volatile given slowing growth in China and a stronger U.S. dollar.
However, with energy companies making up 13% of the BofAML High Yield Master Index and only 7% of the S&P 500, the high yield market is relatively more exposed to the selloff
in crude oil prices.
In the last several years, high yield has benefited from the low interest rate environment induced by the Fed’s Quantitative Easing program, as investors reached for yield.
With expectations of an approaching rate hike, investors are becoming unsettled. The pace of the Fed’s rate hikes is a key factor. Given that the U.S. economy has been steadily improving but at a measured pace, we expect the rise in interest rates to be slow and gradual. Near-term, however, the Fed faces a challenge.
We expect volatility across markets to remain elevated as uncertainties weigh on investor confidence. However, the fundamentals supporting this equity bull market remain intact, and the combination of improving economic growth and accommodative monetary policies in developed markets should continue to support equities over bonds, particularly in our favored regions of the U.S., Europe and Japan.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)