John Walbaum asks if we have forgotten the realities of equity markets and questions whether recent market falls are part of a longer-term collapse.
The equity markets endured some sharp falls last week. Last Monday, the US stock market closed down 4.6%, while falls of a similar magnitude in Japan and Hong Kong were seen overnight into Tuesday. The US and UK equity markets have now fallen around 8% from January highs. But we need to consider this against a backdrop of incredibly low levels of volatility throughout 2017.
While these moves were significant daily declines, we must put this relatively modest correction in the context of the very strong equity performance we saw throughout 2017 and into the beginning of 2018. It was only last Monday that global equity indices closed below year-end levels in local currency, although sterling strength means that they are now back to end-Q3 levels, in sterling terms.
Herding rather than triggers?
The abrupt turn in sentiment suggests some market participants may have forgotten the realities of equity investment after the incredibly low levels of volatility throughout 2017. The acceleration in the sell-off in US equities last Monday also suggests that many investors have sought to lock-in recent profits and sell their holdings before markets fall further, exacerbating the sell-off.
In the absence of any specific triggers, many commentators have been searching for data points, such as the previous Friday's strong US wage inflation data, to explain the recent market moves. Although strong US wage inflation data (alongside record low unemployment) would suggest a buoyant backdrop for equity markets, it is the secondary impact on interest rates that have caused concern for investors. US 10-year yields are as high as they have been for four years and haven't sustained significantly higher levels since the middle of 2011.
A change in market sentiment
While there's a clear shift in market sentiment, it would be premature to suggest that the fundamental backdrop has changed. The US wage inflation statistic is just one data point and some have highlighted the rise in minimum wage in several US states and an unusual drop in hours worked as potential distorting factors. That said, US monetary policy over the last year has reflected a view in the Federal Reserve that the fall in US inflation was a temporary phenomenon.
Alignment of views
Last year bond yields tended to rise ahead of monetary policy changes and then drift back lower, as investors were reassured by short-term inflation numbers. The current behaviour of bond yields might be better portrayed as a greater alignment of view between investors and central bankers, rather than a sudden change to the economic outlook. Of course, should inflation expectations start to rise sharply then equity markets (and of course bond markets) would be vulnerable.
Closer to home, UK gilt yields have risen to levels higher than any witnessed in 2017 over short-to-medium durations. However, at longer durations yields are broadly in line with the levels seen at the end of Q3 17. This increase in yields should help to offset the negative impact on funding levels for schemes that are not fully hedged on interest rates, albeit only partially.
In summary, the increase in yields and sell-off in equity markets does not appear, at this stage, to reflect any significant change to the fundamental market backdrop. Both movements suggest a short-term market correction, rather than a longer-term market collapse.
John Walbaum is head of investment consultancy at Hymans Robertson
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