After a quiet year for market volatility in 2017 and a strong start to 2018 for most stock markets, the last few days have seen a return of normal behaviour. Shaun Port, our chief investment officer, looks at what’s been happening in markets and what it could mean.
On Monday 5th February, the main gauge of the US stockmarket – S&P500 – fell 4.1%: the largest daily fall since 2011. Since the close on 26th January, and at the time of writing, the S&P is down by 7.8% and, following on from the US decline, markets in Asia and Europe are down markedly: Japan (Topix) -4.4%, Europe (Eurostoxx 50) and the UK (FTSE 100) down just over 2%.
What has caused the decline?
The fall in stock markets began last week and really gathered momentum following the release of strong US economic data showing an increase in wage growth. Pressure for rising wages has been signalled for some time by employment surveys, but last week’s non-farm payroll data shows that there is now evidence in official statistics.
Investors worry that rising wages means inflation is likely to accelerate. As a result, there was a sell-off in government bonds, as investors repriced the number of expected interest rate rises from two to three this year. The knock-on effect was bond yields broke key technical levels. And in turn, equity investors have been unnerved by the rise in bond yields, as it is perceived to affect the valuation of stocks.
Moreover, the sharp decline on Monday appears to have been driven by technical factors. With the momentum in the markets rolling over (1-month price return turning negative yesterday) and volatility spiking (the VIX index of implied volatility jumped to 38 yesterday) this has caused many quantitative strategies, such as those run by hedge funds, to de-risk portfolios, leading to a very marked selling and a ‘flash crash’ at around 3:10pm, New-York time, Monday 5th February.
Is this the end of the ‘bull’ market?
The S&P500 had been in the longest period since 1929 without a price decline of more than 5%1 – otherwise known as a ‘correction’. As such, markets have been abnormally calm and a correction had to happen at some point. The question now is whether this turns into something more serious – a ‘bear’ market. We don’t think so, for many reasons:
- A 5% or even a 10% correction in developed equity markets is a normal occurrence even during a ‘bull’ market. The chart below shows the calendar year returns vs intra-year declines
- Rapid sell-offs, such as the one on February 5th, can also be followed by market bounce backs as automated selling becomes exhaustive; there is little sign of long-term investors selling
- Stock market valuations are reasonable, even in the US. The US market is valued at around 16 times next years’ earnings2
- The US and Global economy is growing strongly, for example US service sector growth at a 10-year high3
- The US economy will get a further boost from tax reform and the restraint on government spending is now being lifted in many countries across the world
- There is, as yet, no sign of a pass-through of higher wages into a marked increase in core inflation, something that would prompt a more aggressive increase in interest rates
- Bond markets are likely to stabilise, given that speculators have been aggressively short-selling bonds and bond prices have recovered.
Overall, we believe this setback is temporary given the very strong support for equity markets, even if in the next few days and weeks markets remain volatile. In other words, the more normal behaviour of global markets has returned.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.
- Peter Oppenheimer, Goldman Sachs: “Global Equity Strategy: Correction Detection; the risks of a drawdown within a bull market”, 29/1/18. Defined as a 5% loss within the last six-month period.
- Bloomberg 6/2/18
- ISM Non-manufacturing index for January. Source: Bloomberg