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Recent Market Volatility

In another sign that markets continue to move into a late-cycle, higher-volatility regime, equity markets fell significantly yesterday. U.S. equities registered a 3% to 4% loss led by high-momentum technology names, yet other asset classes, such as bonds, did not react in an outsized way. High-yield spreads widened by 9 basis points and investment grade corporate spreads ticked higher by 1 basis point, well within normal levels. Given the sharp and isolated nature of the equity sell-off, we think that this move is reflective of a positioning-led capitulation and equity prices should stabilize.

Sharply higher rates and growing trade concerns have given way to capitulation in equities. Given the strong macro backdrop, we also do not think this is the “big one.” Underlying growth conditions still point to a low probability of a recession. The U.S. economy is projected to grow at an above 4% pace in 3Q, and the world’s major economies remain in a modest economic expansion. The worst performers during this drawdown have been the high-momentum and growth market segments, areas of the market that have seen a massive uptake in long positioning in recent years. The downward move is being exacerbated by the fact that the U.S. equity market is currently in a buyback blackout period similar to the February episode. U.S. companies typically have a five-week “quiet period,” which limits companies’ ability to buy back stock. We estimate that 90% of the U.S. equity market is under the blackout, and as the calendar moves closer to earnings season in November, this source of demand will come back to support equities. Markets have swung to oversold territory over just a couple days, and in the past, this has consistently led to positive gains over the following month.

Other factors point to an isolated correction vs. a broad reversal. High-beta markets, such as small caps and emerging markets outperformed U.S. large-cap equities, which suggests this is not a broad-based risk-off scenario and is likely to continue. Additionally, credit markets have not corroborated equity sentiment, with high yield and investment grade stable throughout recent equity market volatility.

The sharp rate move from August yield levels has been driven by the strong U.S. growth outlook, a more hawkish Fed, and the initiation of tapering in the Eurozone. We still hold our year-end yield range on the 10yr of 3.00%-3.25% for the following reasons:

1) This recent move has not been driven by higher inflation (YOY core CPI has dropped in the last two releases), which we believe would have to happen to see a sustained higher-yield environment.

2) Given the Fed’s terminal rate of around 3%, still muted inflation, and the market pricing in four additional rate hikes, we don’t see a meaningful rate move higher.

While markets are likely to remain volatile given higher rates, trade tensions, and other macro concerns, we do not see recent market action as a signal to a broader change in the current cycle. We still believe the keys for fixed income allocations going forward will be active duration and curve management, along with a heightened emphasis on issuer selection and relative value within credit allocations. For equity allocations, we added international exposure toward the end of the third quarter, based on overdone negative sentiment, improving data for non-U.S. regions, and attractive valuations. We also tactically moved back to an overweight position in EM equities, based on significant underperformance and a more supportive policy stimulus outlook from China. Despite the recent increase in yields, we still see limited risk of a real hawkish surprise from the Fed. And with the increased policy support from China, we believe this sets the table for upside in EM markets. That said, we have kept our overweight in the region small and resisted adding to it as the stabilization in sentiment has been slow.

There are a few risks to our view that warrant caution. First, the ECB’s balance sheet tapering began this month; we will be watching whether financial condition tightening in the Eurozone spills over to global markets in a significant way. Second, China’s response to escalating trade tensions have been to bolster its economy with both monetary and fiscal stimulus programs. To the extent that that continues, we believe investor confidence should return to EM, but there is still some uncertainty as to how China will conduct its economic policies. Lastly, the U.S. earnings season begins in November with expectations for continued high earnings growth. A downside surprise to earnings could shake investor confidence in the U.S. economic expansion. These scenarios are not our base case, but they could present a risk to our baseline views.

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