How much of this week’s volatility in global stock markets is down to a real shift in the economic outlook and how much is to do with markets losing their nerve is hard to tell.
The case could certainly have been made late last year that markets had become overly complacent, were at risk of entering overvalued territory and were vulnerable to a correction.
The correction never came, perhaps because investors were focused on the fruits of a synchronised global economic recovery and rising corporate profits across the world’s major markets. That bond yields were managing to defy improving global growth expectations by staying down was an added bonus.
This month though, US government bond prices have gone into retreat, with the yields on 10-year US Treasuries moving above the 2.8% mark. While this level of yield might still seem low in absolute terms – and it is – it corresponds with levels we haven’t seen since early 20141.
This is unwelcome news for the US stock market, which has to compete with government bonds in generating a yield that is attractive enough for investors to want to buy.
Another change relates to a new questioning of investor attitudes. Concerns have been growing that the persistently rising markets and historically low levels of volatility of the past year might have been indicative of a fear of missing out (FOMO) among those investors late to participate.
The fundamental argument for this week’s market falls is based on a heating labour market in the US turning hot. The pace of job creation quickened last month and so did wage gains – now up 2.9% over the past year2.
In theory this wages growth will feed through to US core inflation – which has been running at 1.7% or 1.8% the last eight months in a row – meaning that interest rates may need to be raised more quickly than previously thought3.
This is plainly at odds with the state of play during much of last year. The US Federal Reserve, while being unable to explain definitively why wages were staying pretty flat even as unemployment was falling, raised rates three times anyway in the belief that accepted economic theory would eventually prevail.
Markets, on the other hand, were more sanguine. Their average expectations for rate rises consistently undershot Fed forecasts, leaving the way open for disappointment. It’s now looking increasingly likely the Fed was right all along – that wage inflation would arrive eventually and push up consumer prices.
Clearly, confidence has taken a knock. The possibility at least of a significant rise in US inflation has been considered and markets haven’t taken to it well.
Market developments of the past week suggest we may be entering a new investing environment where volatility is above those historically depressed levels we saw in 2017, with markets tripping more cautiously between data releases on the US economy and signals from the Fed.
Corporate results might lose some of their glister if markets think rises in inflation and bond yields could depress future rates of profitability and undermine consumer borrowing.
Bond markets are likely to remain in sharp focus. How bonds are priced by investors depends partly on the interaction between interest rate and inflation expectations.
If markets think rates are rising too slowly to counteract future inflationary pressures, the yields on long dated bonds could rise further. Equally, if the perception is rates are being increased too much, long yields should stay low even as the yields on short-dated bonds rise to compete with the interest rates available on cash.
A further unknown is quite how much tax cuts in the US will add to the mix. With large numbers of companies about to reward employees with one-off bonuses and wage increases based on their new corporate tax rates, consumer demand could be about to see a corresponding spike4.
However, what these fundamental considerations fail to explain is why the Dow Jones plunged more than 1,000 points in just one day on Monday.
There will be all manner of explanations for that – hedge funds, exchange traded funds linked to risky strategies and high frequency trades carried out by computer programmes will be among them.
Whatever the reason, this week’s volatility is important because it has demonstrably shaken any mistaken belief that markets can only move steadily higher when the fundamentals look sound.
Last year may have looked like a relatively easy ride. Historically though, weathering volatility has been the price investors have had to pay for securing attractive returns over the long run. What market moves this week may be telling us is that there is no new normal; that, after an albeit generous interlude, the old rules really do still apply.
1 Bloomberg, 08.02.17
2 Bureau of Labor Statistics, 02.02.18
3 Bureau of Labor Statistics, 12.01.18
4 CNBC, 26.02.18
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