Here’s how portfolio managers are investing now

Despite last week’s market volatility, market fundamentals remain strong, and experts say there’s no fear of a bear market.

Read: Is the bull run over for U.S. equities?

“Our view is that the synchronized global growth story remains well anchored,” says Clément Gignac, chief economist at iA Financial Group and portfolio manager at Industrial Alliance Investment Management, in a market insights report. “Inflation should be climbing slowly from here on, and the Fed will likely hike rates three or four times before the end of the year.”

Read: What market turbulence means for Fed rate hikes

One of the reasons for the sell-off last week is that U.S. 10-year bond yields appreciated from 2.30% to 2.85%, says Dan Bastasic, senior vice-president and portfolio manager at iA Clarington Investments, in market commentary.

“We called for that at the beginning of the year,” he says. “We just didn’t think a good part of this increase would happen in three weeks.”

Also, adds Gignac, U.S. tax reform was quickly priced into inflation expectations.

How to invest

It’s too early to say whether volatility will slow down.

“As we have warned for some time,” says Gignac, “a healthy return of volatility should remain a major theme in 2018.”

Bastasic expects markets will rise and fall by “a few per cent” daily or weekly for the next several weeks “before the fundamental data start to move into the forefront again.”

For now, markets are fairly valued or relatively cheap.

“In the U.S., forward earnings are below 17×,” he says. “That’s not a slam-dunk buy, but given 15-16% expected earnings growth, an economy that’s growing at over 3% and global synchronized growth, these price-to-earnings levels on stocks—and they’re even cheaper in Canada—are providing us with a backdrop for markets to likely appreciate once this bout of consolidation peters out.”

And since equities took a hit across the globe, Gignac says, “Whatever markets you liked in late January, you should now love in February.”

The authors of a Richardson GMP market insights report are giving their favourite names a little love: “We have been taking advantage of the recent market weakness using dry powder (cash) to buy names on our shopping list that are now looking much more attractive.”

For fixed income, Bastasic expects U.S. 10-year bond yields to reach 3.25% by year-end.

“At 2.75%-2.86%, we’ve basically done six to seven months of that yield move in only three or four weeks,” he says. “That will provide an opportunity for defensive stock investing over the next several weeks and going into the end of the year.”

The Richardson GMP authors say that inflation is undervalued by the market and bond yields will continue to rise.

“We have positioned our fundamental portfolios to tilt toward cyclical stocks with a yield, and [are] underweighting interest rate sensitive securities.”

Technical difficulties

Beyond rising rates and inflation expectations, market volatility resulted from several technical factors.

For instance, last week was a “normal course correction,” says Bastasic. “Investor sentiment was at peak levels, and we had a pretty long rally for stocks, especially in the U.S., without more than a 2-3% correction.”

Gignac notes that, prior to the volatility, the S&P 500 recorded its longest stretch without a 3% drawdown since 1950, at 448 days.

“A short-term correction of 10% or more is completely normal,” he says. “Historically, this happens on average every nine months.” (The last 10% correction was in early 2016.)

Further, Bastasic says that at end of day on Feb. 5, algorithms kicked in, adding market pressure. Plus, there was a high volume of ETF trading at that time.

“By some estimates it was about 41% of the day’s total volume, which is a long-term peak,” he says.

The Richardson GMP report says the implosion of short volatility products exasperated the market sell-off.

“These strategies have ballooned in popularity as volatility in the market remained benign for an extended period,” say the report.

The strategy of being short equity volatility goes beyond ETFs to managers using risk parity, shorting long volatility and other similar strategies.

“The massive amount of capital in this trade sucked up a lot of the liquidity in the market, because those investors had to sell stocks to cover their shorts, switch to bonds or chase the losing trade, in hopes that volatility will normalize,” says the report.

Importantly, there was no panic from institutional investors last week.

“On a relative basis, institutional selling wasn’t very high at all,” says Bastasic. “And there was no spike in insurance being bought through options.”

Nor did investment-grade credit spreads widen.

“In fact, they’ve been pretty low and pretty close to all-time lows,” he says. “So in terms of spreads, you’re not seeing the credit markets react to this.”

Read: This week’s equity dip didn’t faze corporate credit

With fundamentals still strong, “This is probably a normal correction that was driven by outsized selling from the passive crowd and the machines, rather than institutional sellers,” says Bastasic. “And that’s a good thing.”

Read the full report from Richardson GMP.