The death of Goldilocks?

 

Matthew Peter, Chief Economist's view 

 

After a prolonged period of subdued volatility in 2017, volatility returned in February with the VIX jumping to its highest level since August 2015. Equity markets tumbled, with the S&P 500 falling more than 8% over the first week of the month.

The catalyst for the correction was stronger-than-expected wage growth data in the US, which caused investors to fear a sharp move higher in interest rates. US 10-year government bond yields surged by 18bps to 2.88% following the data, the highest yield since early 2014. The swift rise in interest rates caused investors to reassess the lofty valuations in the US equity market, which have fallen by over 8% this week, returning the S&P 500 to its level of November last year.

The correction in equity markets has been broad, extending to all major markets. European markets are down around 5% over the week (and will likely open lower on European markets tonight as they play catch up to the S&P 500), the Nikkei is down 8% and the Hong Kong and Chinese markets are down around 10%. The Australian market is currently down just under 5% for the week, outperforming its US counterpart, finding support from the RBA, who continue to signal their intent to keep monetary policy on hold, and a 3% fall in the AUD; outcomes mirrored in Canada, whose stock market is also outperforming the US.

So how worried should we be? To begin, let’s reflect on what most market commentators, including QIC, had been expecting to happen over the course of 2018. The consensus had been that: (i) inflation would gradually rise, as tight labour markets finally begin to generate wage growth, leading central banks continue to tighten monetary policy; (ii) tighter monetary policy would lead to higher bond yields; (iii) higher bond yields would lead to a retracement of equity prices to fair value; and (iv) the equity market correction would lift market volatility from historical lows. The consensus view was the ‘Goldilocks’ assumption: that the correction in asset valuations would be orderly.

Market moves this week have all been in line with the above expectations, except for the Goldilocks assumption that market adjustments would be orderly. But of all the above assumptions, this was probably the assumption at most risk as we know that corrections in financial markets are often abrupt rather than orderly.

However, to move from ‘abrupt’ to ‘calamity’ requires some form of contagion. That is, some form of negative feedback loop either from financial markets to the real economy. As mentioned, the genesis of this week’s market turmoil was last Friday’s US labour market data, which showed wage growth rose to 2.9% in January.

This was a sharp step higher from the originally reported 2.5% (since revised to 2.7%) growth rate in December. However, the other data in the labour report showed continuing strong growth in employment and preceded data earlier in the week showing strong and rising business sentiment (a leading indicator of business capex spending).

More generally, the run of economic data, business and consumer sentiment measures and forward-looking indicators of economic growth are strong and rising across all major economies and economic regions. From the point-of-view of economic fundamentals, the backdrop to any market correction is supportive – if ever there was macroeconomic backdrop that could cushion the impact of a correction in an overvalued equity market, now is the time.

A key factor linking the economic backdrop to equity markets is the outlook for corporate earnings. In the US, earnings in the S&P 500 are expected to rise 12.8% over 2017 and are projected to rise by around 18% over 2018 (according to IBES estimates). Although current forward earnings estimates may prove to be overly optimistic, it is difficult to forecast a weak corporate earnings outlook over the coming year. Earnings momentum into 2018 is strong, given the robust earnings outcomes currently being reported for the last quarter of 2017 (with 78% of companies reporting earnings above expectations), while the favourable macroeconomic backdrop and the recent corporate tax cuts enacted by the US Congress should ensure at least double-digit earnings growth this year.

In a world of robust earnings growth and supportive global macroeconomic backdrop, it is difficult to envisage a calamitous correction in equity markets. However, with inflation on the rise and central banks continuing to tighten monetary policy gradually, the era of low financial market volatility is drawing to a close.

Table 1: Financial market movements, 1 - 8 February 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,581.0

-8.5%

US

2.82%

3.4 bps

US Dollar Index (DXY)

90.31

1.9%

Nikkei 225

21,890.9

-6.8%

Japan

0.08%

-1.9 bps

USD-JPY

108.74

-0.6%

FTSE 100

7,170.7

-4.3%

UK

1.62%

8.6 bps

GBP-USD

1.391

-2.5%

DAX

12,260.3

-5.7%

Germany

0.76%

4.1 bps

EUR-USD

1.225

-2.1%

S&P/ASX 200

5,890.7

-3.3%

Australia

2.89%

8.6 bps

AUD-USD

0.778

-3.2%

Source: Bloomberg

 

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