A confluence of factors point to a heating economy
A healthy correction may not be the end result of the global market rout
Markets began February with a heavy thud as US equities fell by 10 per cent from their January high, sending other equity markets cascading around the world.
However it was not long before the sell-off appeared to settle down, which seemed to bear out those analysts who considered the drop to be no more than ‘healthy correction’. In fact the number of Bloomberg stories mentioning ‘healthy correction’ hit a record high during last week. Time will tell whether this turns out to be accurate, but it is worth remembering that consensus assumptions rarely are.
The idea that the sell-off was relatively healthy fits neatly into the narrative that it was mostly caused by technical factors, namely the unwinding of short volatility trades where positioning was extreme, and so is nothing really to worry about as fundamental factors remain supportive. According to James Bullard at the St Louis Fed it was the most predictable sell-off of all time, while Bill Dudley of the New York Fed described the market slide it as "small potatoes". Again, however, snap judgements such as these can quickly be made to look premature, and by the end of the week this was already looking the case.
Yet it is wrong to think that fundamentals were absent in the sell-off and equally wrong to think that a technical sell-off linked to derivatives is nothing to worry about. After all, it was algorithmic models that fanned the flames of the financial crisis in 2009 whereas this time around the risk is that derivatives have become the tail that is now wagging the dog. But there are also reasons to be worried that investors are being complacent about some of the fundamental forces at play.
For one thing, the selling began in reaction to the rise of US Treasury yields following the January non-farm payroll report, and in particular to the pick-up in average earnings growth to its fastest pace since 2009. So the sell-off was started by good news, but clearly news that was not widely expected. Investors have for some time underestimated the likelihood that inflation might rear up and that the Fed could be forced to raise interest rates by more than the three times suggested by its dot plot. The market has adjusted its assumptions closer to the Fed’s, but it is still not pricing the possibility that the Fed itself is being too cautious, and will have to raise rates more than three times this year.
Another danger is that it is actually the Fed’s ultra-easy policies over the past few years that have perpetuated cycles prone to periodic booms and busts. In addition markets have become used to an unhealthy feedback loop whereby the Fed often responds to equity weakness by delaying increases in interest rates, begging the question of whether it is the markets or the Fed that is in control of monetary policy. Last week this pattern was in evidence as bond yields initially fell back when equity markets started to fall, seemingly in the belief that the Fed may pause again. However, with a strong economy such a reaction is unlikely to be sustained, meaning that if bond yields continue to rise on good economic data, which seems likely, the equity market may continue to feel the strain.
This likelihood is amplified by the global nature of the recovery, as the Fed is not the only central bank intent on raising interest rates. Last week the Bank of England also signalled that rates in the UK are likely to rise sooner and faster than it previously indicated. It may also be amplified by the news out of Washington, where Congress passed a budget that looks set to cause the fiscal deficit to balloon in the coming years.
New Fed Chairman Jerome Powell will have an opportunity to address the latest volatility when he testifies to Congress near the end of the month. However, events may already be running ahead of him if inflation data in the coming week confirms that price pressures are finally resurfacing. Such an outcome is likely to keep bond yields headed higher, which may mean that equities will have to endure more volatility than a "healthy correction" might seem to imply.
Tim Fox is Group Chief Economist & Head of Research at Emirates NBD