Volatility is back
As the end of 2017 approached, many were suggesting that 2018 could see a return to more unstable markets. With the bull market in full swing and volatility at record low levels, there were signs that a level of complacency had crept into some investors.
The overnight falls in the US and Asian stock markets will have surprised many with their severity, not least because the S&P 500 Index saw its largest single-day fall since August 2011 while the VIX (the volatility index) saw its largest one-day rise in history. However, as is often the case, the bond market has been pointing towards some potential problems for some time as worries over the future path of interest rates had started to increase. The US 10-year yield was just above 2% in September, however as evidence has increased that the US economy is in robust health, this same yield has increased sharply to just under 2.8% today.
The trigger point for this week’s sell-off seems to be the US non-farms payroll data on Friday afternoon, which came in strongly ahead of expectations. With the US economy growing strongly, there are fears that the Federal Reserve will have to raise interest rates faster than had previously been expected. With three rates rises in the US in 2017, and three more earmarked for 2018, incoming Chairman of the Federal Reserve Jerome Powell may be in for a challenging time.
With the global economy benefiting from ultra loose monetary policy for many years following the financial crisis in 2008, we have clearly entered a new phase, as liquidity is being withdrawn from the financial system. The challenge is to find the best method of ending this financial experiment in a controlled manner – and that is an experiment in its own right!
The current environment is also not being helped by a higher level of inflation than many central banks would like. As yet, this is not translating into wage pressure, but should that come, then central banks may have no choice but to raise interest rates faster than expected.
However, when markets move as sharply as this, it’s important to keep a sense of perspective. Global growth remains strong, with unusually synchronised growth happening all around the world, while corporate earnings in 2017 showed that good quality businesses can make strong returns. In many respects there are signs that the market is behaving more rationally, with companies that are beating expectations being strongly rewarded, and those that aren’t being punished. This in turn should create increased dispersion in returns and see a return to what may be described as more ‘normal’ market conditions.
For us managing the AJ Bell investment solutions, we continue to stay true to our investment philosophy. That is to take a long-term approach and avoid being swayed by short-term noise and events in the markets. With such benign conditions for so long, it is easy to become complacent and think that markets going up every day with almost no volatility is normal, and for many new to investing in recent years, this will be all they have known. However, the last few days are a healthy reminder to everybody that markets have a habit of jolting you out of your comfort zone.
In the coming days and weeks we expect there will be more volatility and instability as investors adjust their thinking as to what the future path of interest rates and inflation really is. This will create more headlines and worry, but the key will be to remain rational and calm, and take a long-term perspective. After all, no market can go up in a straight line forever and mid-cycle corrections are certainly nothing new.