Key takeaways
  • The Dow Jones Industrial Average (Dow) and the S&P 500 Index fell into correction territory on Thursday, February 8, but the concerns of these markets have not spread to other key financial and commodity markets.
  • Yet, stock-market corrections do not necessarily change the economy’s course, and we still see an economic backdrop that should favor equities.
What it may mean for investors
  • The emerging budget deal in Congress bears watching, but we still see opportunities in equity and fixed income markets.
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How did the correction result? What may its financial-market scope be?
An abrupt rise in interest rates, concerns about rising inflation, and a potentially more hawkish Federal Reserve have created an equity market tantrum that now has the Dow and S&P 500 Index  in full correction territory (a correction is a price decline of between 10% and 20%). As of Thursday’s market close, the Nasdaq Index was close to correction territory but not there yet.  
We view this correction as more technical, and sentiment-driven, and we do not believe that it signals a material change in the economic fundamentals. Global reflation, combined with U.S.-dollar weakness, created investor complacency that ideal liquidity conditions would continue indefinitely. As calm markets pushed volatility to record lows, some strategies increasingly accepted bets against calm markets in order to fund equity positions. When volatility returned and stock prices fell, these strategies have had to sell holdings to cover losses. Other investors sought to take profits and self-reinforcing selling then began. 
Sanguine reactions in other markets also have given encouraging signs for equity investors. Credit markets have held up relatively well, in contrast to corrections in 2014 or 2015 and 2016, when credit spreads widened materially. Said another way, there has been no real flight to perceived safe havens (gold, the U.S. dollar, and U.S. Treasury securities). Commodity prices also are still relatively flat year to date, while currencies such as the euro and yen also have been resilient. 
What does a correction mean for the economy and other markets?
Market corrections against a strong macro backdrop are historically common, and they do not necessarily derail the economy. Since 1928, the S&P 500 Index has had a decline of at least 10% approximately every 11 months. Until this week, the index had not had a correction since January and February 2016. The October 1987 equity-market decline, sometimes called “Black Monday,” shares some similarities with the current sell-off. Then, as now, the economy was strong enough to generate some higher inflation. Yet, after the 1987 stock-market crash, the economy continued to grow until the next recession in mid-1990. 
Our constructive economic outlook implies that the correction’s scope should be relatively limited. Even before tax-cut and federal spending stimulus, the U.S. economy’s organic growth rate was improving. The fiscal stimulus should drive even stronger domestic corporate revenue and earnings growth, and we believe that a 2018 recession is unlikely. Recent increases in inflation expectations have triggered repricing in the fixed-income markets, but we expect inflation and bond yields to trend only modestly higher. As bond investors find their preferred yield levels, some equity volatility may persist. We continue to expect new highs in equity prices this year—but with a bumpier path higher than in 2017.
What impact could the congressional budget deal have on markets?
The new federal budget  plan matters and is increasing defense and nondefense spending to the tune of $300 billion, which would put the fiscal year 2019 deficit at over $1 trillion or 6% of gross domestic product (GDP).  To say the least, it is unusual to have the deficit expanding at time when the U.S. economy is growing and unemployment is this low. This will put an upward bias to GDP growth and domestic interest rates.
When will the correction end?
It is very difficult to predict a correction’s duration. Any break below the S&P 500 Index 200-day moving average, around 2,538, could signal more losses for the S&P 500 Index in the near term. Equity markets may rise or fall from day to day, as some investors are forced to sell, but others see value and bring liquidity to the market. Yet, the substantial cash still available in investor portfolios should finally attract buyers and greater market stability.
What market opportunities may there be?
We view the present environment as an opportunity to add quality equity holdings at this level or at cheaper valuations. If the market sell-off continues, favoring cyclical sectors that can grow top-line revenues and are indexed to an improving 2018 macro backdrop has merit. These include the Consumer Discretionary, Industrials, Financials and Health Care sectors. We would maintain reduced exposure to Utilities, Consumer Staples and Energy holdings here. Within fixed income, we suggest raising average credit quality, particularly focusing on investments in areas like high-grade corporate and municipal bonds. We would reduce exposure to non-investment grade bonds (high-yield debt). We have favored nominal exposure to Treasury Inflation Protected Securities (TIPS) for some time, and we continue to do so in this environment.