The Fed’s hike does not baffle the markets

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This pushes the schedule of interest rate hikes forward, as inflation expectations rise for this year.

However, the real surprise was that investors did not react more strongly; As markets edged down in the week of the release, stocks rebounded.

Despite the projection:

  • The 10-year US Treasury yield actually fell over the month to 1.5%.
  • The S&P 500 continues its bullish momentum, gaining 2.3% (USD) over the month and hit a record high
  • Europe continued its rally with the Euro Stoxx 50 at 0.7% (EUR)
  • US services PMIs peaked in May, retreating in June, while eurozone services PMIs surprised on the upside
  • The Nikkei 225 lags behind at -0.1% (JPY)
  • The VIX started to rise before the Fed signal, reaching 21 in the following days. By the end of the month, it was back to 16, hitting its lowest level since before the pandemic.

Warming up: US inflation picks up again in May

Low volatility might not be a good sign

That said, we don’t see low volatility as a good sign and while markets don’t seem shaken by the Fed’s surprise forecast, volatility could return if a catalyst emerges.

Far from indicating favorable forward-looking conditions, the absence of volatility may suggest that market participants do not recognize the problems ahead.

Fundamental investors, who would normally sell in reaction to negative developments, appear to be holding back or reluctant to act. They may have finally capitulated, having tried to sell bad news several times, but then found dynamic traders buying the bearish and pushing the markets higher.

If this is correct, the market’s ability to anticipate future macroeconomic developments may be reduced and the pricing of important information may be slower than normal.

This is probably a big reason for the low volatility, and we expect this to persist, in the absence of a catalyst.

Potential volatility catalysts

Another example of a substantial negative development, which so far has not seen an obvious market reaction, is the antitrust legislation presented to the US Congress, where there is significant bipartisan support.

Six antitrust bills, which could have a huge impact on some of the biggest names in growing technology, have been passed by the House Judiciary Committee.

The law on the end of monopolies on platforms, or “Break Up Bill”, is a particularly strong potential threat for some of the biggest growth stocks.

In addition, Lina Khan, a highly regarded critic of the “monopoly” practices of technology companies, has been appointed to the Federal Trade Commission (FTC).

We’re watching for catalysts that could trigger a spike in volatility beyond these antitrust bills, including inflation, jobs, and Federal Reserve meetings.

“Focus on the world, not the region”: Global equity income funds and the sectors that shine and sin

Investment implications

We remain constructive on the outlook for global growth. However, we reduced the risk in early June, as we expect increasing volatility in risk assets heading into 2H 2021, significantly driven by a likely rise in global interest rates.

The recent sharp decline in overall market volatility, which we believe is due to the aforementioned reluctance to act on the part of fundamental investors, means that investors may consider increasing their risk exposure in ways tactical, if they see that they are now particularly defensive. This is until they see a catalyst that can compensate for this effect. However, a lot depends on the risk profiles of the individual portfolios.

Over the longer term, the three factors investors should focus on are fundamentals, valuations and sentiment, all of which point to the potential for higher volatility.

Fundamentals point to a negative outlook for equities, given very likely headwinds such as tapering, combined with upward pressure on real rates.

Other growing headwinds are rising corporate taxes in the United States, the G7’s breakthrough on a global minimum tax, and regulatory pressures affecting growth stocks.

Valuations are also tight, especially in growth sectors such as technology.

Finally, investor sentiment, a contrarian indicator, is positive, with stock flows significantly increasing and the AAII Sentiment Survey signaling strong bullish sentiment.

As a result, we have not changed our mind and are still oriented towards value versus growth.

Andrew Harmstone is a Senior Portfolio Manager on Morgan Stanley Investment Management‘s Global Multi-Asset Team



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