A New Era of Uncertainty?
The NYSE trading floor. Source: Investopedia
It has seemingly become normal for markets to engage in dramatic swings during volatile times. For example, after the COVID-19 pandemic began, market indices fell by around half before recovering completely and rallying to all-time highs.
Now, even as the pandemic appears at an end, this phenomenon in the stock market will remain, with the higher-than-normal volatility now more a feature rather than a bug.
After the October inflation report came out in mid-November, the Russell 2000 surged by 5 percent, and the S&P 500 saw a 2 percent increase. Many analysts feel that this was an overreaction; yet, the rise in equities has continued unabated. Over the past month, the Dow has climbed by 7 percent, and since hitting its 3-month low on October 25, the Nasdaq has risen by 13 percent.
Analysts believe that what is happening now is a shift in the market narrative. A fear of higher-for-longer interest and bond rates has turned into increasing hope for rate cuts and a gentle economic landing, with low inflation data throwing that shift into overdrive. Bearish investors, who had hoped the Federal Reserve would remain hawkish amidst the sharp drop in bond yields during early November, gave up. This caused a wave of short-covering, further increasing the effects of the narrative shift.
However, in fundamental terms, everything has been moving rather slowly. For example, the inflation report did not deviate significantly from estimates, and despite widespread predictions of a recession, interest rates are holding steady; in fact, growth remains extremely strong despite the record interest rates, and only recently did the economy begin to show signs of cooling. The recent GDP report revised the Q3 GDP growth figure up by more than expected, reflecting upgrades to business investments, state and local government spending, and investments in home construction. The fall of retail sales has only been a recent development.
As a symbol of how the market narrative has been changing a lot faster than the fundamentals underlying it, Deutsche Bank strategist Henry Allen suggests that there were six other times since 2021 that investors anticipated a dovish pivot.
A graph of 2-year Treasury yields since 2021. Source: WSJ
While these changes did not drastically impact the United States, they reflect deeper issues that are unlikely to be resolved soon. Severe shocks, like the wars in Ukraine and the Middle East, trade disputes between the United States, China, and Europe, the failure of SVB, Signature, and Credit Suisse, have led to rapid moves in inflation rates and bond yields. The implied volatility of treasuries has been the highest on average over the past year of any time outside the dot-com bubble burst and the Great Financial Crisis, according to the BofA Move index.
There is also deep uncertainty about the long-term trajectory for the economy. Is there a fundamental shift in the economy, implying sustained higher interest rates and inflation? Or could there be a return to the pre-pandemic norm of lower rates and greater concern about deflation than inflation? Based on the current trend of de-globalization and higher government spending, concerns leaning towards the former appear accurate.