Inside Markets — Volatility

A corrective phase based on concerns around weakening economic growth may only last 1-2 months if the slowdown is deemed to be short or shallow. Downside in equity markets is currently being driven by multiple compression from an increase in realized volatility. Once equity volatility reaches elevated levels (VIX >20) it usually takes at least a couple of months to return to subdued levels that support multiple expansion. When volatility returns to subdued levels, we could see investors ‘looking across the valley’ at the start of the Fed’s easing cycle. The Fed funds rate is ~100bp above the neutral rate and resilient labor data ahead of the September FOMC meeting are unlikely to stop the committee from moving toward neutral.

Our year-end target for 2-year yields is now 3.20% and we’re looking for 10-year yields to finish the year near 3.50%. We see inflation breakeven yields ending the year at +200bp, which would still leave 10-year real yields at restrictive levels near +150bp.

Rate-sensitive equity groups (REITS, Financials, Homebuilders) would be the best performers assuming those yield targets are reached and the RTY will have another chance to close its performance gap with the SPX.