Last week’s equity market gyrations felt pretty dramatic. The US market dropped 5%, the worst week in two years. Europe took its cue from the US, with the FTSE100 and German DAX also down almost 5%. The VIX Index, a measure of equity market volatility, also known as the ‘fear gauge’, shot up from what, until recently, have been very low levels.
The trigger for the sell-off was an unexpectedly sharp rise in US wages. This cast doubt on one of the central ideas behind the boom in equities, that inflation, and interest rates, will rise only slowly. For the last ten years the equity market has been able to count on cheap money. Suddenly it looked as if that assumption might be at risk.
Interest rate expectations are a key influence on equity values. Low interest rates boost the current value of future expected dividends and are associated with improving economic activity. Take away low interest rates and equities look less attractive.
This did not start ten days ago. Market expectations for interest rates have been creeping higher in the US, and to a lesser extent Europe, since the end of 2016, reflecting an improving global economy. Interest rates, or yields, on government bonds have moved up significantly since August of last year (although not so much in Japan). Over the last year the US Federal Reserve has raised interest rates from 0.25% to 1.5% and has signalled that a further 75bp of rate hikes are on the cards this year.
Until last week the equity market shrugged this off. The good news on stronger growth and profits more than eclipsed the upward drift in interest rate expectations, powering US equities to new highs through January. The strength of the latest US wages data came as a wake-up call to the risk of higher interest rates.
As equity market sell offs go, last week’s mini panic was small beer compared to the sell-offs that have punctuated America’s nine year equity bull market. The peak to trough decline in the S&P500 index last week was 6%. That compares with a 15% fall in 2010 during the euro debt crisis, a 15% decline following the downgrade to America’s credit rating in 2011 and a 14% fall in 2015-16 on fears of weaker global growth.
Those episodes were deflationary shocks, triggering worry about weak growth and collapsing inflation. Last week’s sell off was the opposite, an inflationary shock, caused by worries that strong growth and inflation would cause the Federal Reserve to tighten monetary policy faster than previously expected.
Something similar happened in 2013, in what was dubbed the taper tantrum. Hints from the Fed that it was planning to wind down its purchases of US treasuries through quantitative easing caused a sell-off in bond markets, raising US bond yields and hitting emerging market equities as foreign capital inflows into emerging markets were temporarily reversed. Emollient words from the Fed and a decision to hold back on winding down QE ended that sell-off.
Last week’s event are a reminder of what could go wrong. History shows that unexpected rises in inflation and interest rates can rout a long bull market in equities.
At least until last week sentiment about the equity market was verging on the euphoric. In the US the latest data show that equity analysts are more bullish about equities than at any time in almost 40 years. The American Association of Individual Investors reports that private investors in the US increased their holdings of equities from 66% to 72% of their assets last year, the highest level since the dotcom boom in 2000. Bank of America Merrill Lynch’s reports that, despite recent gains, most institutional investors do not expect equity markets to peak until 2019 or later.
There is no agreed method for judging equity valuations. One I like is Nobel Laureate Robert Shiller’s CAPE ratio, which compares the share prices of US companies to the 10-year average of their real earnings. In the last 120 years there have been only two occasions when, on this measure, equities were more overvalued than they were before last week’s sell-off: on the eve of the Great Crash of 1929 and during the dotcom boom of the late ‘90s. That is not to say that the market is heading down. Stretched equity valuations can get more stretched. As Professor Shiller put it in Davos last month, high though his CAPE measure is at the moment, it is, “not even close to” levels seen at the peak of the dotcom boom.
The fact that we are starting from a position of ultra-lose monetary policy is a complicating factor. Interest rates are miles away from what, until 2008, counted as normal levels. To fully unwind quantitative easing, the Fed and the European Central Bank would have to sell over $5 trillion of securities back to private buyers. Gradual though it is likely to be, it will eventually mean a huge withdrawal of liquidity from the financial markets, just as QE poured vast amounts of liquidity into the system.
Bond markets have plenty to worry about. Higher inflation, the unwinding of quantitative easing and a surge in US bond issuance to finance tax cuts and higher in public expenditure are bad news for bond investors. Under the Trump Administration public sector austerity seems to be over in the US. Official projections show the US budget deficit rising from $529 billion in 2017 to $955 billion in 2018.
The better-than-expected wage growth in the US, combined with tighter labour markets in the UK and Europe, means central banks are having to consider reversing easy monetary policy more quickly.
Even in Brexit Britain the outlook is brightening. Last week the Bank of England raised its growth forecasts, and now expects the pace of growth to remain around the 1.8% level seen in 2016 and 2017 through 2018 and 2019. This means faster rate rises than previously expected. Markets now expect the Bank to raise interest rates twice this year and see a greater than 50% chance of the first one coming at the Bank’s next meeting in May.
Central banks are alive to the risks of tightening monetary policy too quickly. Their aim is to slowly normalise monetary policy without derailing the recovery or collapsing equity markets. But the world is unpredictable. For all their attempts at reassurance, central banks cannot be sure where the economy or policy is heading. As ever, there is no consensus on where equity markets are heading. But looking at the weekend papers there seems to be general view that financial volatility is hear to stay.
William McChesney Martin, Chairman of the Fed in the '50s and '60s, remarked that it was the job of central bankers to "take away the punch bowl just when the party gets going". Last week sell off is a reminder of how quickly the equity market can switch from partying to punch bowl anxiety.
PS: German employers struck a landmark deal with the country’s largest workers’ union giving a 4.3% pay rise to 900,000 workers and the right to reduce their working week to 28 hours. The deal, which employers have described as a “burden, which will be hard to bear for many firms”, highlights the power of collective bargaining in tighter labour markets.