Article by Matthias Busuttil
Over recent weeks, since 26th January to be exact, financial markets have seen the most notable spike in volatility experienced over the last two years. The calmest period in financial markets since the 2008 crisis has been swiftly disrupted by the mounting concerns on inflation risks in the United States.
Despite the ultra low level of unemployment in the US, currently 4.1%, the Federal Reserve (“Fed”) was still awaiting to see signs of wage growth pressures - not the quantum of jobs created but the level of capacity utilisation within the labour market. Market players have therefore been eyeing the monthly US non-farm payroll reports, giving particular focus to the average hourly earnings growth figure in order to anticipate changes in monetary policy by the Fed and reassess the inflation outlook in the US.
January’s employment report which was reported on 2nd February showed the strongest rate of wage growth recorded since May 2009. The year-on-year increase in average hourly earnings reported for January came in at 2.9%, exceeding market consensus expectations of 2.6%. This piece of information gives the Fed a long awaited sign of rising price pressures in a tight labour market environment which strengthens its position on normalising monetary conditions.
This was the main driver that ignited the initial sell-off in the US Treasury Market due to the rising concerns on the pace of inflationary developments taking the 10-year yield to 2.90% - the highest level yet since the January 2015. Likewise, in Europe the 10-year German bund yield spiked to 0.80% which is the highest level since September 2015. These moves represent a 0.50% rise in the US 10-year yield and a 0.40% rise in the German 10-year yield as of the start of the year.
Since the introduction of accommodative monetary policy by the major central banks, the low inflation outlook, low interest rate environment and monetary stimulus were, at least until now, the fundamental pillars which sustained the concurrent rally in bonds and equity markets - which incidentally also explained the relatively high correlation between these two asset classes. It therefore comes to no surprise that as the inflation outlook becomes risky, the same correlation that coupled the two asset classes played against the equity market following the shake-out in the bond market. This sparked the largest drop in equity markets over the last 2 years. The S&P 500 index in the US slid by circa 12% while the Euro Stoxx 600 index dropped by circa 8% from 26th January to 9th February – the trough of the correction.
While the impact of inflation on equity valuations underpins the motive of this correction, it is difficult to explain the abruptness and the magnitude of the slide in equity markets. Some notable factors which have exacerbated the equity sell-off where related to the market’s reaction to take profit on equity positions and reduce risk exposure in a highly volatile market. There has also been the implosion of Exchange-Traded Notes (ETNs) that allowed investors to bet on low volatility, effectively kicking them out of their position. Market participants have also cited volatility-targeting strategies that automatically sell risky assets in response to market turbulence which exerts further downward pressure on the market.
Given the upward trajectory in equity valuations and bond prices and a high degree of market complacency built up during a period of extremely low volatility, the shake-out in both bonds and equity markets may be seen as a “healthy correction” whereby market risk premia may be re-equilibrated to the intrinsic value and fundamental evaluation of the underlying securities.
Despite the correlated movement we have seen in equity and bond markets over the last few years of monetary stimulus, the rising threat of their common enemy (inflation) may not necessary imply the same fate for both asset classes. The economic backdrop has shifted dramatically since the recent crises. Both the US and the European economy have made strong improvements in stimulating investment and consumer demand, lowering unemployment and strengthening the financial position of the banking sector.
Economic growth prospects are positive in the US, especially given their mild tilt towards fiscal stimulus, as well as in Europe, when considering the improvement of government finances and the rise in domestic demand. Some investable entities may be poised better than others to benefit from stronger growth prospects and overcome the threat of rising inflation. While a passive strategy of “buying the market” has served investors brilliantly when markets where moving only in one direction, the market environment we are slowly moving into may present active managers with an opportunity to deliver superior returns to clients through careful investment selection and market timing.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.