Volatility Strikes Back In Big Way

Volatility Strikes Back In Big Way
new sense photo brian selzer

OCEAN CITY — Last month we saw one of the most volatile weeks in recent history. The S&P 500 plunged by 5% on Monday, extending its decline to nearly 12.5% from its May high, while volatility as measured by the VIX Index1 spiked to 41, reaching an intraday high of 53. However, stocks rebounded later in the week on dovish comments from Federal Reserve Bank (Fed) of New York President William C. Dudley, who said that raising interest rates at the September FOMC meeting seems less compelling than it was a few weeks ago.

Thus, the S&P 500 correction from its peak in May earlier this year tapered to 7% by the end of last week. China’s plunging stock market, fears about looming Fed rate hikes, concerns over global growth, weakness in commodity prices and prospects for more currency volatility will remain the major sources of uncertainty. However, we expect developed markets led by the U.S to remain on a positive growth trajectory and central banks in Europe and Japan to keep interest rates low. Focus remains on China Equity volatility began to rise, when Chinese policymakers surprised the markets on August 11 and 12 with a series of devaluations of the yuan. This and other recent Chinese monetary policy actions raised concerns about China’s economic growth, a potential currency war with its Asian trade partners, weaker commodity prices and a spillover into global growth. After all, China’s economy comprises roughly 15% of world gross domestic product (GDP), and a third of global growth, according to BofA Merrill Lynch (BofAML) Global Research, and as a result global equities tend to be influenced by the path of China’s growth. Chinese equities have plummeted in recent months on concerns over slowing growth, leverage, and capital outflows.

At the end of last week, the Shanghai Composite had fallen by roughly 37% from its high in June despite Chinese authorities’ interventions to stabilize markets. Last week, China’s central bank cut the one-year benchmark loan interest rate and the deposit interest rate, as well as the reserve requirement ratio. It also injected CNY 200 billion into the interbank money market via short-term liquidity operations. China also intervened directly in the equity market to stem the selloff, according to undisclosed sources. In light of this, we expect more policy actions from China going forward.

The Fed seems willing to begin raising rates on the basis of the cumulative improvement in the U.S. economy, but is still deciding whether the economy will be able to withstand the policy move when the rest of the world appears to be rocked by market volatility. As a result, the September decision appears to hinge on two factors: how robust the U.S. economy will appear based on what we now see as a very strong second quarter and the next jobs report due out September 4; and how much turmoil remains in global markets over the next two weeks leading to the meeting.

BofAML Global Research economists continue to expect the Fed will hike interest rates in September, provided market turmoil subsides. The market-implied probability of a September hike has risen from 25% to about 40% in the past few days. At the Jackson Hole central bankers’ annual conference over the weekend, Vice Chair Stanley Fischer discussed the domestic and international reasons for slower-than-expected inflation. He reminded markets that ultimately the Fed would set monetary policy for where it anticipates the economy will be in the future – not where it currently is.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)