What a difference a day makes. I started to write this commentary yesterday following sharp falls in global equity markets of around 7% from their peak in late January.Indeed, 2018 started with the strongest rally in global equities since 1987, largely fuelled by the US tax cut which boosted earnings forecasts, the US market up over 7% in January and global equities up over 5% in local currency terms. Unfortunately, the UK equity market missed out on this rally in January, largely as a result of sterling strength and concerns regarding the failure of the infrastructure company, Carillion, which had extensive contracts with the UK government.
Then, today, the US market has re-gained its composure, with the S&P 500 back above 2,700 and volatility returning to average long-term readings. The FTSE-100 in the UK and Euro Stoxx 600 indices have had their best days since April. Whilst a ‘dead cat bounce’ is not uncommon after a large market fall, such a significant rally is unusual and potentially reflects the appetite for investors to buy on a market dip.
What Caused the Market Sell-Off?
Janet Yellen’s last meeting in January as head of the US Federal Reserve resulted in no action on interest rates, but an upgrade in inflation forecasts. It worried markets as historically complacency in the face of inflation does not end well.
Rising inflation expectations manifested itself in the US 10-year Treasury Bond yield, which peaked at 2.88% on Monday, a sharp rise from around 2.5% at Christmas and 1.5% from its low point in mid-2016. Bond yields may yet go higher, especially if new economic data shows the latest US tax cut is stoking inflation. Many commentators are talking of 10-year US bond yields hitting 3% in the coming months.
It appears the market falls were exacerbated by algorithms and computerised trading which were triggered by the surge in bond yields and inflation expectations. Huge trading volumes were processed which magnified market declines in a short period of time, until markets stabilised.
The uncertainty was increased as Jay Powell took over as head of the US central bank, as yet untested despite assertions that he intended to continue with the policies of Janet Yellen. In due course, he will need to set clear direction on the plan for interest rate normalisation, ie. the pace and trajectory of interest rate rises, as well as how quantitative easing (QE) will be unwound over time.
Inflation Tantrum 2018
The severity and abruptness of the market fall invites comparisons with the so-called ‘Taper Tantrum’ of 2013. As Mark Twain noted, ‘history does not repeat itself, but it rhymes’. The Taper Tantrum in 2013 involved a surge in US Treasury yields after Ben Bernanke, head of the US Federal Reserve announced a reduction in the level of economic stimulus. The bond market witnessed an abrupt sell-off, which spilled over into a sharp decline in global equity markets. However, the market stabilised relatively quickly after investors realised there was no reason to panic. History may show that 2018 was an ‘Inflation Tantrum’, a temporary de-stabilising of equity markets as central banks re-calibrate their policies to normalise the global economy and manage the exit from QE in the aftermath of the financial crisis of 2008.
Positive Supportive Economic Environment
However, unlike 2013, it is not just the US which is enjoying healthy levels of economic growth. This year, there is synchronised global growth, including emerging markets.
In addition, corporate earnings have been growing strongly. The employment market is buoyant and wages are picking up in many parts of the world.
Today, the US market is broadly back to where it started the year in dollar terms. In terms of valuation, the forecast earnings multiple (Price/Earnings) on the S&P 500 is now about 17, down from 20 at the end of last year. The UK FTSE-100 has underperformed other markets and is currently about 5% lower than it started the year due to sterling strength and adverse sentiment. This underperformance may unwind if sterling weakens in light of possible concerns later in the year regarding uncertain progress with Brexit negotiations.
Inflation may remain subdued
However, inflation may not necessarily take off any time soon. Core inflation in the developed world remains low by historical standards, wage demands remain modest and the strong secular forces of technological innovation and an ageing global population, as well as high levels of public and private debt are strongly deflationary. Indeed, whilst talk of deflation is now off the agenda, a bear market in bonds is not a foregone conclusion unless the path for interest rates is steeper than now anticipated in response to strong economic data.
Equities should recover and reflect continuing economic global growth
In summary, my base case has not altered for this stage. Despite the events of the last week, I still consider that equities will continue to appreciate in 2018, although investors need to be ready for periods of volatility and accept that it will not be plain sailing as was the case in 2017. This is likely as central banks grapple with maintaining growth and financial stability, as well as keeping a lid on increasing inflationary pressures by increasing interest rates and a managed exit from QE.
Such volatility can act as a useful reality check on valuations preventing market bubbles, as well as providing the opportunity for investors to buy on dips.
In terms of our approach, towards the end of last year we reduced risk slightly in discretionary portfolios by introducing more diversification, such as property and in more cautious portfolios, quality bonds. Indeed, this latest spike in volatility vindicates our position – the economic backdrop and corporate earnings are favourable. The positive economic environment should support equities for some time to come, but we must remain vigilant and dampen volatility as far as possible by balancing equity exposure with other types of uncorrelated assets.
Please note, this article is for information only and does not constitute investment or tax advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise; pension rules and tax legislation are subject to change. If you would like investment or pension advice on your individual circumstances, please do not hesitate to get in touch on 01392 875500 or info@SeabrookClark.co.uk