Reality Bites

Stocks go down; stocks go up – but not usually by so much in a short space of time. In this week’s blog, we’ll look at why markets have been on such a wild ride and – crucially – what this might signal for the rest of 2018. Equity and debt markets have enjoyed a ‘Goldilocks’ era of improving growth, but still low inflation. This couldn’t last forever and in 2018, we could hear more from the bears – but how loudly will they roar?

Why now?

We could ask, “why not?” Big swings are unusual, but so was the previous sense of eerie calm and lack of volatility.  Markets had become accustomed to loose monetary policy and more lately, rallied hard on US tax changes. Global economies were growing in unison. But, this had raised not only earnings prospects, but also inflationary pressures and the chance of further rate rises. The Federal Reserve had already said in December that it expected three rate hikes in the next year.

Therefore, 2018 looked like bringing to an end the sweet spot of rising growth and still ultra-low interest rates – but it took a few events to really bring this home.

Why right now?

US bond yields have risen sharply in the last month – at least in the context of their recent slumber. Inflation and market congestion concerns pushed the 10-year Treasury to 2.88% – a four year high. More specifically, commentators are pointing to last Friday’s US employment report, which appeared to show a significant increase in wage inflation suggesting that the Fed would need to take more aggressive stance on interest rates.

Where the US leads, the rest of the world follows – or feels the pain.

US Treasury yields and inflation expectation

 Is it that simple?

On one level, it is. As Torsten Slok, Deutsche Bank’s chief international economist, put it:

…it is the threat of higher inflation and higher rates that is worrying the stock market because higher wages means lower profit margins and higher inflation means faster rate hikes from the Fed as the FOMC tries to slow down the economy and ultimately the revenue growth of S&P 500 companies.

But, there is at least one problem with this narrative. Average hourly growth in December was 2.9% YoY – the fastest pace since June 2009. But, this effectively offset a sharp drop in previous months. So, was it really just this one data point that triggered such a big fall in global markets? The sheer complexity of equity and debt markets, their derivatives and the increasing size of quant-driven funds makes it impossible to give a simple answer.  Algorithmic trading and investors rapidly exiting leveraged short volatility products does appear to have significantly magnified the selloff.

Once this sell off ended, markets began to show some signs of recovery– albeit not yet regaining previous levels.

So does all it mean anything?

Short answer – Yes.

Big picture: this week has highlighted fundamental issues – primarily the changing economic and market climate we can expect in 2018. The actual mechanics of how this happened is secondary to the fact that the disparities existed and investors are now more aware of them.

This week the Bank of England has also indicated that the pace of interest rate increases could accelerate if the economy remains on its current track. MPC minutes show that the committee believes that they would need to rise “earlier” and by a “somewhat greater extent” than they thought at their last review in November. The narrative has changed and markets are playing catch-up.

Three more specific takeaways for 2018

  1. Beware market sensitivity.Or, as Jon Authers puts it in The Financial Times this week: “Accidents tend to happen in more dangerous conditions”. The current economic climate isn’t especially dangerous per se, but a market consensus based on a limited world-view can be – especially when investors have gotten themselves into small nooks in search of yield and trades are potentially very crowded.Expect high sensitivity to data while markets adjust. Investors may struggle to find easy exits, triggering sharp falls. Companies raising funds should beware turbulence.
  2. Things aren’t that bad… The global economy is still growing more strongly than it has since 2010. There are challenges, but also opportunities a-plenty. The year has started with a bang M&A wise. US earnings should soon benefit from tax reform – potentially increasing deal activity. The sell-off in corporate bonds primarily came at the riskier end, where things have been tricky for a while.In short, the capital markets aren’t the economy. Nothing has essentially changed in terms of the recovery. Not as good as before, but better than of late…but (as before) beware market hubris, complacency, the impact of rate rises, protectionism and geopolitical strife.
  3. …except where they are..
    As we saw to a more extreme extent in 2007, changing economic and market circumstances change the equation on some market products – like bets on low volatility. They force investors to shine a brighter light on their positions in general. UK profit warnings have triggered higher increased share price falls since mid-2017 – with even bigger sell-offs at the start of 2018. This increase typically signals that investors are less inclined to treat warnings as less of a one-off and are instead reading signs of a deeper, structural issues. UK sectors under greatest structural pressure, e.g. Support Services, Retail – have seen some of the biggest falls.UK profit warnings vs. media share price fall

    As our latest EY ITEM forecast indicated, the UK’s growth is falling behind Europe and the US and can only be described as ‘mid-range’. Domestic pressure is evident in the recent jump in profit warnings from mid-cap companies and especially in retail. We expect more UK companies to show strain in 2018.


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