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Extreme equity market volatility in February but credit drops only marginally and infrastructure holds steady

Equity markets dropped 10% between late January and early February. This price weakness has not spread to other asset classes

Winter 2017 / 2018

15 January 2018

VIX experiences largest 1-day increase and Dow Jones falls 10%

The equity markets experienced extreme volatility in February 2018 that resulted in the CBOE Volatility Index (VIX) spiking to 37.32 on Monday, 5 February, up 115% from 17.31 on the previous trading day and its largest-ever percentage 1-day increase. The VIX then traded to an intraday high of over 50 on 6 February before closing at 29.98. It has since re-traced about half of its spike.

Exhibits 1 and 2. VIX Index (30 days) and Dow Jones Industrial (12 months)

Sources: Chicago Board Options Exchange, S&P Dow Jones Indices

The Dow Jones fell from a recent high of 26,604 on 26 January to 23,938 on 5 February, down 10%, and has since traded back to 24,583. The sell-off was triggered by inflationary fears from the strong January 2018 non-farm payroll number released on Friday, 2 February. Jobs were up by 200,000 and the unemployment came in at 4.1%, a 17-year low. This led to concern that the Fed will raise its target federal funds rate faster than expected. This concern is supported by a strong US economy that is now operating at a zero or even positive output gap (i.e., operating at or above full production capacity), and it will get a further fiscal boost from the corporate tax cuts enacted in December 2017 and the budget deal signed in early February 2018.(1) The Fed had been expected to raise rates 75 bps in 2018 in three 25 bp increments. This would take the benchmark fed funds rate to 2% to 2.25% from its current 1.25% to 1.5%. Some economists now expect four 25 bp rate increases this year.

Over the longer-term (e.g., 12-18 months) stocks may be in the process of making a top, as investors look further ahead and realize the "trifecta" of stronger economic growth, still-low inflation and world central bank stimulus cannot last forever.

US core inflation firms and 10-year rates hit 4-year highs

Core CPI for January was released on 14 February. It was +1.85% yoy vs. a +1.7% median forecast, and +0.35% mom vs. a +0.2% median forecast. The yoy print was the third increase in four months and the mom increase was the fastest pace in 12 years. As a measure of inflationary expectations, the US 5-year breakeven inflation rate has risen from 1.54% on 20 June 2017 to 1.91% on 14 February 2018 and it has been increasing since 9 February 2016 when it bottomed at 0.96%, its post-crisis low.(2) This shows inflationary expectations are anchoring and core inflation may continue to drift toward the Fed’s target of +2%. Inflationary expectations are an important determinant of actual inflation.

Exhibit 3. US 5-year breakeven inflation rate and US core CPI (three years)

Sources: US Bureau of Labor Statistics, Federal Reserve Bank of St Louis

At the same time, the Fed is reducing its balance sheet which implies higher long-term rates. The 10-year treasury yield is at a 4-year high at 2.91%, up from 2.06% in early September 2017. The 5-year treasury is 2.54%, nearly an 8-year high. Goldman expects the 10-year to be 3.25% by year-end 2018.

US High Yield prices fall less than 2%

Equity price weakness did not, however, spill over to other asset classes such as credit. The CDX North American High Yield index fell only two points or 1.8% during the same period (26 January to 5 February) that the Dow fell 10%. Credit has held up, due in part, to dramatically reduced investment grade supply (down 46% YTD through 8 February) which has supported spreads. This reduced supply is due to the December 2017 corporate tax cuts scheduled to go into effect in 2018 and 2019. These have attracted cash held offshore by US companies and reduced the need for funding.

Exhibits 4 and 5. CDX North American High Yield Index and US High Yield spreads (three years)

Sources: CDX Index Company/Markit, ICE BAML

The real threat to corporate credit is wage growth which was +2.9% in January, up from +2.5% in December 2017, and Goldman Sachs expects 3% to 3.5% growth for the full year 2018. Payroll is normally the largest component of a company’s operating expenses, especially in the services industries, and significant wage growth could hurt operating cash flow and consequently increase net debt as measured by net debt/EBITDA. Debt levels are already stretched in the US and higher for most sectors than in 2006.

Infrastructure debt holds steady

There has not been any noticeable drop in the infrastructure market as its asset prices have a low beta to the equity market because most of their price risk is idiosyncratic and not systematic risk or market risk (see Sequoia Research, “Equity betas for listed infrastructure funds,” Winter 2015 / 2016). Most infrastructure debt is also floating rate so it has minimal duration risk from long-term rates rising. It also benefits from short-term rates rising because the margins reset higher as libor increases.

Appendix: US budget deficit

Congress has voted twice in the last two months (the December 2017 tax cuts and the February 2018 budget) to increase the federal deficit at a time when the economy shows no need of fiscal stimulus. This has caused concern about a ballooning budget deficit. The additional spending is for only two years and is $143bn in 2018 and $153bn in 2019, plus $85bn in emergency relief spending (see Exhibit 6).(3) There undoubtedly will be additional budgets lifting the 2011 spending caps in the future as there were recently in 2013 and 2015.

Budget deficit higher than normal at this late stage of the business cycle

At this stage of a business cycle (it will be nine years in June 2018), the US economy has typically operated at less of a budget deficit than it is now. In one case in the last 50 years it operated at a surplus during 1998-2001. In the final two years of the last three expansions (excluding the current expansion), the budget as a percentage of GDP ranged between -3.07% and +2.30% for an average of -1.05%.

The current and expected near-term deficits are much larger, however. The deficit was 3.47% in 2017 and is expected by the Office of Management and Budget (OMB) to be 4.16% in 2018, 4.69% in 2019 and 4.47% in 2020 and assumes GDP growth of about 3.0% for the period. Goldman Sachs expects budget deficits of 3.9% in 2018, 5.2% in 2019 and 5.3% in 2020. Their estimates assume GDP growth of 2.9%, 2.2%, and 1.5% for 2018-2020. Their estimates are also after the tax cuts and the February budget and represent upward revisions of 0.10-0.20% vs their earlier estimates. Actual GDP was +2.5% in 4Q2017, +3.2% in 3Q2017 and +3.1% for 2Q2017. The long-term post war average GDP growth rate is 3.22% from 1947 through 2017.

Exhibit 6. Budget deal reached in February 2018 is for only FY2018 and FY2019

Sources: US Department of Commerce, US Treasury, Goldman Sachs Global Investment Research

As long as the Treasury can borrow at a blended nominal interest rate below the nominal growth rate of GDP, which is expected to be the case for the next several years, these elevated budget deficit levels are considered manageable for the US economy. This is especially the case during a period of moderately strong economic growth and due to the resiliency of the US economy, but they bear watching in case GDP unexpectedly weakens or interest rates meaningfully climb. By comparison, in 2017 the EU as a whole had a 1.5% budget deficit, Germany operated at a 1.2% surplus, the UK had a deficit of 2.4% and Japan had a deficit of 4.5% in 2016.(4)

While the continued growth of public debt raises eventual sustainability questions if left unchecked, the level of US national debt at the moment (about 100% of GDP) is within the range of several other DM economies, albeit at the high end of the range.(5) Where the US is more of an outlier is in its budget deficit.

Budget deficit source: Goldman Sachs and Sequoia research

(1) 2Q2017 actual GDP was $17.03tn and potential GDP was $17.13tn. Potential output is the maximum amount of goods & services an economy can turn out when it is most efficient – that is, at full capacity. It measures the economy’s potential to produce goods & services based on the current supply of people working and how productive they are. In downturns actual output drops below potential and slows inflation. In advanced stages of expansions, output can exceed potential and cause the economy to overheat. Often, potential output is referred to as the production capacity of the economy.
(2) The 5-year breakeven inflation rate is the market’s current expectation of where inflation will be in 5-years. It is calculated as the difference in yield between the 5-year Treasury Inflation-Protected Securities (TIPS) based on CPI and the nominal 5-year treasury note. The yield difference between the two is the breakeven inflation rate.
(3) Military spending will increase $80bn in 2018 and $85bn next year. The limit on nondefense spending will increase $63bn this year and $68bn next year, which includes an incremental $10bn in 2018 and 2019 for infrastructure. There is also an additional $85bn in emergency relief spending not subject to caps. All years with regard to the budget are US fiscal years (FY) that run from 1 Oct. through 30 Sept., e.g., FY2018 is 1 Oct. 2017 through 30 Sept. 2018.
(4) It is worth noting that in 2012 Japan’s deficit was 8.1% of GDP, yet the yen was still considered to be a safe haven and it was one of the most expensive assets in the world at USD/JPY 78. Its safe haven status, however, was driven largely by the European Sovereign Debt Crisis which began in 2009 and intensified in 2012 when S&P downgraded 10 EU countries, Greece was given a second bailout and its government bond yields soared to over 30%.
(5) The average debt-to-GDP rate for Canada, the UK, France, Belgium and Austria is about 95%.
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