February was a tough month for investors. After a nice start to the year in January, markets experienced a bout of volatility. There are several different undercurrents contributing to the disruption and they are still being digested.
First, we have the Federal Reserve talking about the pace and timing of short term rate hikes. For the first time in a long time, market participants find the Fed’s forecast for rates to be credible. This has caused market participants to rethink things like valuation and the net effect of higher short term rates on corporate cash flow, particularly among more indebted companies.
Second, there are some concerns about inflation. Between the budget deficit in the spending bill, tax cuts, increases in workers’ average hourly earnings, and the protectionism coming out of the White House, investors seem to think we could see prices march higher. They may be right over the short term, but whether the higher prices stick and the wage effects are permanent or transitory remain to be seen.
Third, we have a number of more technical factors at play in the market. A large segment of investors pursue strategies targeting a specific level of volatility in portfolios. When volatility rises, such strategies sell stocks to get the volatility level of the portfolio down, causing more volatility and more selling. It is a feedback loop and it goes until it stops.
So what do we think? All else equal, a normalization of Fed policy is a good thing, but it clearly means a period of adjustment for markets. How long it takes the market to digest the change is anyone’s guess. The Fed is also aware of the effect they have on markets and the effect those markets have on the underlying economy. We would expect the changes to be “data dependent” rather than set in stone, as long as they don’t do too much too fast, we would expect the effects to be more of a reset than a recession.