Equity falls are a sign of normality

Ed Monk
Ed Monk
Fidelity Personal Investing5 February 2018

Markets have reacted negatively to positive economic news as the week gets underway.

Shares across the world dipped, with falls of more than 2% on some Asian markets and their European counterparts down between 0.5 and 1%.

It has been back down to earth with a bump for investors who have enjoyed a serene entry into 2018. The price falls have been reflected in a sharp rise in the VIX - the CBOE Volatility Index that indicates levels of calm, or the opposite, among investors.

Bond markets, too, have fallen, extending their losing run from last week.

The cause of the sell-off is, perversely, strengthening economic news, particularly in the US. On Friday, jobs data showed a better-than-expected increase in the wages of American workers. Such wage growth is exactly what has been missing from an otherwise widespread economic recovery - so why the negative reaction in markets?

The answer is that it has raised expectations that the US Federal Reserve will now raise interest rates - and potentially shrink the Fed’s balance sheet of asset purchased under Quantitative Easing - more quickly than had been anticipated. Cheap borrowing costs and demand from central bank bond-buying has underpinned the strong run for capital markets.

The Fed’s monetary policy has turned and is now in a tightening phase, but the pace of that tightening has been slowed by inflation that has not returned as strongly as you’d expect. Whether tightening has to happen more rapidly is a question now under the purview of Jay Powell, who took over from outgoing Fed chair Janet Yellen this month. He would be forgiven for bemoaning having been handed such a finely balanced judgement so early in his tenure.

Yellen departs amid widespread praise for her ability to communicate the Fed’s intentions and of avoiding tantrums in markets while beginning the process of returning monetary policy to something like normality. This week’s price fluctuations show that this was no small feat, and that Powell will have his work cut out to match her success.

A similar task lies ahead for the Bank of England, with the first test coming as soon as Thursday when the Monetary Policy Committee announces its latest decisions on the Bank rate and quantitative easing, as well as publishing its Quarterly Inflation Report. If growth and inflation forecasts are updated, markets are likely to conclude that interest rates will have to rise faster than is currently priced in.

If that transpires, you can expect further violence in stock markets.

At such times it’s worth investors remembering that volatility is the price we pay for the chance of better long term returns from equities, and that price swings after such a long period of calm are bound to feel alarming.

For many years now, markets have been supported by abnormal central bank policy and that will have to unwind at some point. Having that happen because economies are strengthening, and can therefore withstand higher rates, is something to be welcomed, even if it means a bumpy ride for portfolios.    

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