Not widely welcomed, but arguably overdue?
The sharp sell-off in stocks that started last week and gathered steam this week lacked a specific trigger — unlike the last time US shares fell this much, which came in the wake of the US losing its AAA sovereign rating at S&P Global Ratings in 2011.
As with plane crashes, the experts are pointing to a confluence of factors, from concerns over the path of Federal Reserve interest-rate increases to a rapid unwinding of trades predicated on continued low volatility in markets.
As is often the case, global markets take their lead from the US and the week ending the 2nd of February saw the biggest weekly decline in US equities since the Chinese slowdown fears of early 2016 with the selloff continuing on Monday. The fall of 2.1% on Friday took the S&P 500 down 3.9% for the week, with the index falling a further 4.1% yesterday (5 February).
Despite more mixed data recently, it’s not the health of the US economy that is worrying US (and world) markets, but rather inflation. Most of the falls come after Friday’s announcement of a stronger than expected 2.9% year on year rise in average hourly earnings. The fear is extremely low unemployment is (finally) driving wages up significantly which will inevitably lead to higher inflation and thus higher rates from the US Federal Reserve. At some point, the fear is that whilst growth may be strong, higher rates lead to lower stock prices through mechanisms such increased debt costs for companies, future profits being discounted back to present day at a higher rate and bonds with higher yields looking more attractive relative to expensive equities.
Now, to be clear, as the chart below from the FT shows, the pullback so far is only a blip in the context of the massive run-up in US equities prices over the past 5 years so another valid reason for the selloff is that markets had just run too hard recently. The sell-off so far has only erased January’s gains.
But there are undoubtedly some areas of the market that have already reacted more strongly than the US equity market. Although it pulled back yesterday (5 Feb) as risk aversion kicked in, 10-year US treasuries closed at 2.84% on Friday, the highest in over 3 years and way above the downward trend-line in place since the 1980s (something that is exciting bond managers such as Bill Gross).
There are also some patterns bubbling along that don’t make sense given the increasing likelihood of US rates rising more quickly than expected. Notably, the weakening of the dollar, which has been in place since the beginning of 2017 and which, as discussed, has continued this year. Rising rates should mean a stronger dollar, particularly if you think that Trump’s tax cuts will lead to repatriation of company profits held in other currencies.
We don’t have a crystal ball, so we don’t know for sure what will happen over the rest of this week. It may be that market participants step in to buy the dip (as they have done for the past almost 2 years) or the sell-off may accelerate over the short-term. A longer-term sell-off seems unlikely though, as severe bear markets tend to coincide with recessions and the proximate trigger for this particular sell-off actually appears to be stronger than expected growth. However, even during the good times, we never ignore the fact that markets are inherently risky and it’s never a good idea to rely on them rising forever. We have positioned appropriately for this uncertainty, continuing to rely on diversification as well fund manager expertise to ensure client portfolios remain robust to surprises.