Equities and fixed income markets have been surging in the last year on the back of steady, synchronized global growth, the resolution of some thorny political issues, and the passing of the US tax reform. Yet risk was rising. Equity valuations had risen to levels justified only in relation to US treasury yields. Even if the rise in yields was slow and orderly, the risk posed by a possible correction in the yield flattening, possibly from a rebound in inflation expectations, meant that markets were correlated through a common factor, and therefore riskier than before. A rational investor would have either a) reduced portfolio risk, or b) hedged that common factor by shorting 10 or even 30 year treasuries. Or both. Given the strength of fundamentals, it would not have been entirely irrational to ratchet up equity exposure while buying put protection. The duration hedge will very soon be de rigueur.
Investors will then have to, and likely will, question their prognosis of the underlying fundamentals. Yes, growth has broadened across the globe. Yes, trade has rebounded and pulled manufacturing and commodities up with it. Yes, European politics has come to have a blunted effect on markets. And yes, technology provides a healthy cap on inflation tendencies. But there are caveats. The growth we currently experience has been bought by artificial stimulants: ultra-loose monetary policy. Has the world economy achieved escape velocity? And while trade has rebounded it has been QE charged domestic growth that has pulled global trade along, not the converse. With protectionist voices rising in Washington and matched in Beijing and Brussels, can the rebound in trade consolidate into a new growth stage? Technology has indeed improved the lives of many, and suppressed pricing pressures by increasing efficiency, but as tech advances from human leveraging to human replacement, what will be the consequences on the labour market and society. This is a longer term question. As for political risk, it has more recently been swept aside rather than laid to rest. The Italians go to the polls in a month with the Democrats splintered and Five Star ascending, leaving the opportunity or risk that the centre right’s Forza Italia led by former PM Berlusconi could end up as king maker. Has anyone noticed that the Germans have yet to form a government 4 months after an indecisive election, or that the AfD now have 94 seats in the Bundestag (and 12.6% of the vote)? Meanwhile Catalonia remains in limbo as pro-independence parties captured the majority but their likely leader remains in exile and unable to take office. And in America, Donald Trump struggles with an investigation into Russian meddling in US politics.
Finally there is the question of inflation. Inflation is notoriously difficult to measure. Sometimes the best way to measure it is to poll the public for their anecdotal experience. Inflation breakevens have been rising of late, yet the yield curve has flattened. The Fed has been resolute about its rate hike plans and indeed one Fed governor is contemplating 4 instead of 3 hikes for 2018. Will rate hikes suppress demand and slow inflation or will rate hikes stoke inflation? Whatever it is, the market is as yet unprepared for a rise in inflation.
Last week, equity markets took a tumble together with the bond market as inflation and rate fears took hold. It was a small correction, hardly worthy of comment under normal conditions, but things haven’t been normal for over a year. What of credit spreads? High yield and investment grade spreads widened but not by a lot. Loan spreads hardly budged. Are fundamentals being more rationally priced in credit markets as opposed to equity markets? The concerns in the equity markets and over valuations centre around what multiples can be supported by current government bond yields. Credit spreads feature a more explicit distinction between duration and credit risk and may therefore be less sensitive to underlying sovereign yields. The loan market which is a floating rate coupon market will have even less dependence on the sovereign bond market. That said, rising rates implies higher debt service costs for all corporates which is credit negative.
The movement of the USD supports our theory that USD weakness was a sign of lower risk aversion and that the USD is still a good haven currency.
For now, the small correction last week is just that, but it is a healthy reminder that markets don’t go in straight lines.