All streaks come to an end at some point and we were finally reminded of that with a good old-fashioned market correction (a drop of 10%+ from the prior peak) during February. After an impressive run of gains in 14 of the past 15 months, the S&P 500 Index fell by 3.89% (that one month, March 2017, was essentially flat). At one point, the index fell by 10.2% versus its prior peak (February 8) before staging a rally towards month-end that recovered about two-thirds of the drop. The last correction prior to February 8 was almost two years ago (February 11, 2016).
The Dow Jones Industrial Average fell 4.28%. Small-company stocks - as measured by the Russell 2000 Index - dropped by approximately 4%.
Equity volatility (as measured by the CBOE SPX Volatility Index, aka, the “VIX” or the “fear index”) spiked early in the month but later dropped to levels still well above what investors experienced during 2017. Four trading days posted at least a 4% spread between the high and the low, compared with only two sessions that did so over the past five years.¹
There was no shortage of reasons provided for the return of long dormant volatility. Commonly cited explanations include: expectations that the Federal Reserve may be compelled to raise its short-term policy rate more aggressively in response to higher inflation; trading strategies tied to low market volatility; a rising federal budget deficit; trade protectionism; and a weaker U.S. dollar.
Dow Jones Industrial Average
|S&P 500 Index
|Russell 2000 Index
|MSCI Europe, Australasia, and Far East (EAFE) Index
|MSCI Emerging Markets Index
|Bloomberg Barclays U.S. Aggregate Bond Index
|Bloomberg Barclays Municipal Bond Index
Source: Bloomberg. Equity indexes are price-only and do not include the impact of dividends. Bond indexes are total return.
International markets fared worse than the U.S. The MSCI All-World ex. U.S. Index fell by 4.94%. The MSCI EAFE Index, which tracks developed international markets, declined 4.71% and the MSCI Emerging Markets Index slid 4.73%.
The yield on the benchmark 10-year U.S. Treasury note climbed 15 basis points (0.15%) to end the month at 2.86%. On February 21 the yield hit 2.95%, the highest peak since early January 2014.
The Bloomberg Barclays U.S. Aggregate Index - a broad-based benchmark of the U.S. taxable, investment- grade bond market - fell 0.95% as rates rose and credit spreads widened
The high-yield bond market, as measured by the Bloomberg Barclays U.S. Corporate High-Yield Bond Index, slid 0.85%.
Municipal bonds, as measured by the Bloomberg Barclays Municipal Bond Index, slipped 1.41%.
Despite the equity market volatility and its status as a safe haven during periods of financial market stress, the spot price of gold fell 2% during the month.
A Check on Manufacturing
Contrary to the common belief that U.S. manufacturing has been hollowed out by countries such as China or by multi-lateral trade deals (e.g. NAFTA), recent statistics point to a factory sector that is quite healthy.
According to the Institute for Supply Management (ISM), its manufacturing composite index (PMI) rose to 60.8 during February from 59.1 in January (Exhibit 1). This represents the highest level achieved since May 2004 and it significantly exceeded expectations of 58.7.² The PMI is a diffusion index where a reading of 50 and above indicates an expanding manufacturing sector. The growth is also widespread as 15 out of 18 industries reported growth during the month.
According to Haver Analytics, there has been a 76% correlation over the past ten years between the level of this index and quarterly growth in real gross domestic product (GDP). The February index suggests that the Q1 GDP print will solidly exceed 3%.
The surge higher in February was led by higher inventories (Exhibit 2) and supplier delivery indexes. The production index (Exhibit 2) dipped during the month to 62 from 64.5 last month, its lowest reading since last October. New orders (Exhibit 3) also fell slightly from 65.4 to 64.2 in January. However, keep in mind that readings above 60 are still considered quite robust, but indicate a slower pace of growth than in January.
The export orders index surged to 62.8, a level not achieved since May 2011. This statistic strongly suggests that overseas economies are expanding overall as well.
The employment index (Exhibit 3) of 59.7 strengthened to its highest level in five months and is up sharply from the January 2016 low. If U.S. manufacturing employment is struggling, it doesn’t appear in the numbers the ISM compiles.
|Exhibit 1 ||Exhibit 2
The prices paid index surged to 74.2, the highest level since May 2011. A total of (27) commodities were reported higher in price and no commodities fell in price during the month. Keep in mind that many commentators will attribute this rise to an acceleration in inflationary pressures as the economy gains strength. However, I believe it is still too early to make this call. Prices rise and fall due to changing supply and demand conditions. Econ 101 postulates that in a competitive global market, the price for a specific good or service will vary until it settles at a point where the quantity of that good demanded will equal the quantity supplied. This is very different from inflation, which is a decline in the monetary standard (and a topic for a future discussion).
The strength in manufacturing is not confined merely to the U.S. Recent manufacturing composite PMI reports in the Eurozone and Japan also signal healthy expansion in those regions.
Recent corporate tax cuts signed into law, as well as ongoing deregulatory actions, should also serve as an additional booster shot to U.S. manufacturing.
The U.S. remains a manufacturing powerhouse. Sure, we don’t specialize in textiles or basic product assembly much these days, however our manufacturing tends to be more of the specialized, value-added variety. Pharmaceuticals, medical devices, aircraft and related parts, heavy trucks, construction and farm machinery, and chemicals, are just some of the key items manufactured - and exported - to markets across the globe.
This happy picture could be derailed by the imposition of steep tariffs on raw steel and aluminum that the Trump Administration recently announced. Trading partners could take aim at some of the items listed in the previous paragraph and respond with retaliatory tariffs. As of this writing, the tariff order is not a done deal so hopefully the President will reconsider. U.S. (and global) manufacturing has considerable momentum; it would be a shame to unnecessarily throw sand into the gears.
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1 Source: S&P Dow Jones Indices
2 Bloomberg survey of 71 economists