Market update: Too far too fast

In this week’s market update: shares and bonds tumble as investors worry about the return of inflation; corporate loans fuel a late cycle acquisition spree; and central banks are in focus as the Bank of England meets and Jerome Powell takes over from Janet Yellen.

Stock markets have tumbled around the world following one of the worst falls on Wall Street in the past 10 years.

The Dow Jones index fell by 4.6% while the broader S&P 500 was 4.1% lower at the end of a panicky session in which investors followed through on last Friday’s 2% tumble in New York.

Markets in Asia followed suite, with Japan hardest hit, down more than 6%. Chinese shares were also sharply lower.

As ever when markets correct after a long period of low volatility, investors struggled to pinpoint the exact trigger. But the blame is largely being pointed at the bond market, where yields have risen sharply so far this year in anticipation of rising inflation and so higher interest rates.

This is a classic case of apparent good news actually turning out to be bad. The reason yields are rising is the strength of the economy and the health of the jobs market.  That’s good news for Main Street but bad for Wall Street because higher interest rates and bond yields mean a squeeze on corporate profits and more competitive alternatives to the high-flying stock market.

The trigger for the ongoing equity market correction was Friday’s non-farm payroll employment data in America, which showed a continuing strengthening of the US jobs market. Not only were a healthy number of jobs created last month but wage growth, for so long notable for its absence, is finally on the way back.

Earnings rose by 2.9%, prompting the suggestion that the missing piece of the inflation jigsaw may at last be put in place after years in which deflation, persistently falling prices, has been the big concern.
The initial impact of more rapidly-rising interest rates was felt, as it always is, in the bond market. Here the yield on the 10-year US Treasury bond, which moves in the opposite direction to bond prices, hit a four-year high of almost 2.9% last week. It started the year at just 2.43% and was only 1.5% 18 months ago.

Overnight, 10-year yields fell back sharply as the usual inverse relationship between equities and bonds reasserted itself.

Rising bond yields are bad news for shares for two reasons. First, they raise the cost of borrowing for companies and so reduce their profits. Second, they make fixed income investments more attractive than riskier equities. This is particularly bad news for equity sectors which are appealing because of their high dividend yield - utilities for example.

Investors always look for a reason why share prices should fall and rising bond yields are the easy explanation right now. But the popular narrative is not always right. It is equally possible that both shares and bonds have simply risen too far too fast and a correction is due after two unusually calm years in the markets.

Since the start of the year until the recent peak on 26 January, the S&P 500 index had risen 200 points from 2674 to 2873, a 7.4% rise. That was an unsustainable rise in less than four weeks and it is worth reminding ourselves that the two day fall has simply given back the recent gains. The market is back to the level it stood at just before Christmas when we were celebrating one of the best years in the market for a long time.

It is also important to see the latest fall in context. During the sovereign debt crisis in 2011 there were several days in which the stock market fell by 4% or more.

These kinds of corrections are to be expected especially when the market has been unusually calm. We have not had a correction of more than 5% in well over a year. The latest rout was well overdue.
Where next? No-one knows, of course, but it should be remembered that bear markets are rare in the absence of an economic recession. That looks unlikely with global growth expectations actually rising. The reason bond yields are rising is that the economy is strong and wage growth returning.

One final point. We often say that time in the market is more important than timing the market. This is because reacting hastily to bad days in the market like these often results in investors missing out on subsequent bounce backs. And the cost of missing out on few strong days in the market can have a devastating impact on long term returns.

An investor who responds to volatility is often doomed to be behind the curve and will pay a heavy price. Hindsight is a wonderful thing, and we all wish we had pre-empted the correction, but anyone who missed out should beware compounding the issue by also potentially missing the bounce.

The spike in bond yields and the equity market volatility it has triggered provided an unwelcome backdrop to the weekend handover of the Federal Reserve chairmanship from Janet Yellen to Jerome Powell. It will also give Bank of England governor Mark Carney pause for thought ahead of this week’s monetary policy committee meeting and Inflation Report.

Yellen’s four years in office have generally been seen as a great success. She has managed the Fed’s twin mandates - controlled inflation and the promotion of full employment - while reversing policy from monetary easing to modest tightening. And she has done this with skilful communication that has - until now anyway - not spooked investors.

As for investors, it may well be that for central bankers too it is better to travel than to arrive. Having brought the Fed to its current tightening bias in a relatively painless way, it may well be that Janet Yellen has chosen the right moment to bow out before things turn a bit uglier.

Jerome Powell has a markets background - he is a lawyer and an investor. One thing that he will be watching closely is the growth of debt-financed mergers and acquisitions, typically a feature of the top of the economic and market cycle.

The deals so far in 2018 have not only been bigger and more numerous than has been the case throughout the recovery, they have also started to rely more and more on borrowed money. Private equity firm Blackstone is leaning heavily on debt to fund its proposed $17bn takeover of Thomson Reuters data and terminals business. It will raise $14bn in leveraged loans and high-yield bonds.

News of this came just a day after Dr Pepper Snapple agreed to an $18.7bn takeover by JAB Holdings, which is also using a mixture of loans and bonds to finance the deal.

Although high-yield bonds offer a better income to investors, there are growing doubts about whether this adequately rewards them for the higher risks taken in financing this sort of takeover. The gap between high-yield bond yields and those on safe government bonds - known as the spread - is now lower than at any point since the credit boom in 2007, which as we all know ended badly.

The risks are heightened as inflation fears return and government bond yields rise. Without an equal rise in the high-yield bonds the spread will get even tighter. If rising bond yields reduce companies’ profitability then the risk of default increases.

Towards the end of most economic cycles, companies make the mistake of gearing up their balance sheets, lulled by a false sense of security as confidence is high and the cost of borrowing low. A fall in high-yield bonds often precedes a similar fall in equities so this is worth keeping an eye on.

What will sustain equity markets in the face of rising bond yields is corporate earnings, especially if the pre-Christmas Trump tax cuts start to boost profits as expected. The cut in the main corporate rate from 35% to 21% is expected to boost average earnings by about 8%, taking the full year gain this year to an estimated 17.4% according to Credit Suisse. That would be the best since 2010.

It needs to be because at 18 times forecast earnings the valuation of the S&P 500 is higher than its medium-term averages. To be a bull of the stock market at today’s levels you have to expect earnings growth to continue.

This week sees another decent pipeline of company results announcements in a wide variety of sectors. BP will give an insight into how the recently stronger oil price is starting to flow through into energy sector profits. Ryanair will update on an airline sector which has seen significant upheavals this year with both Monarch and Air Berlin collapsing. Rio Tinto will shine a light on whether the Chinese slowdown is impacting commodity producers. We will have numbers from Disney and GlaxoSmithKline.

Tax cuts may be boosting the US stock market, or at least offsetting the downward pressure from rising yields, but in India tax emerged this week as a significant cloud over the 2017 bull market in that country’s equities.

Indian shares rose by 30% last year as emerging markets came back into favour but last week’s budget put a fly in the ointment with the introduction of a 10% capital gains tax on shares held for more than a year.

Since 2004 holding shares for just 12 months was enough to make the holding CGT free. The measure was introduced by the Congress party government in an effort to spur interest in the then lacklustre stock market.

Whether the new tax will derail the ongoing bull market remains to be seen. The bull case is that share prices are underpinned by an entrenched shift in Indian savings towards financial assets rather than real estate. 

And finally, Brexit. After another weekend of in-fighting and speculation about a leadership challenge to the Prime Minister, Downing St came out fighting on Monday by clarifying that Britain was ‘categorially leaving the customs union” and would not attempt to replicate it.

That sounded like a victory for the Brexiters, for whom membership of the customs union is a red line. But the Remainers, including home secretary Amber Rudd and Chancellor Philip Hammond, appear relaxed. The reason: there was no mention of when Britain would actually leave the customs union.

Many on the Soft Brexit side of the argument now believe that Britain will stay in the single tariff area until long after the proposed two year transition is over. Why? First, because there is no resolution over the Irish border that would make leaving the union possible; second, because Labour appears to be edging towards staying in the customs union; and three because there is growing acceptance that leaving before new third country deals are in place would be economically damaging.

As they say, you couldn’t make this up.

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