This week’s modest declines in equity markets may be the largest of the last nine months but that is only an illustration of just how far equity market volatility has fallen. The narrative of rising bond yields and inflation expectations is being used to explain the market declines. This is understandable and we ourselves have previously highlighted the anomalously low level of global bond yields. However, rising yields are a known risk for 2018 and unlikely to create a major sell-off in equity markets by themselves. We would be more concerned if there was firm evidence of a meaningful slowdown in economic momentum. Such evidence is – for now – largely absent in either Europe, the US or China.
On the other hand, evidence for rising inflation pressure, as unemployment falls to a record low since reunification in Germany and is at a cyclical low in the US, is relatively easy to find. Only over the previous weekend, a breakdown in negotiations with IG Metall, the German metalworkers’ union, in respect of a 6% pay increase and more flexible working conditions means industrial action is likely in coming weeks.
Unions clearly feel they have a stronger hand in a German labour market where anecdotal evidence of skills shortages is becoming widely reported. Similarly, skilled workers in the US are becoming increasingly hard to find, as measured by the increasing time to fill such skilled vacancies. US small business expectations for wage increases, which tend to lead the reported data by 12m have also moved sharply higher over the past year.
Despite the uncertainty over the slope of the Phillips curve in academic circles, the data on the ground is indicating that pricing power is finally returning to labour. On the surface, this may be welcomed by central banks fighting too-low inflation as another signal their policies are working. Improving labour market conditions and rising wages may even be heralded as the start of a self-sustaining recovery. But given the lag between actual inflation and monetary policy, this only reinforces our expectations that exceptional monetary policy measures will continue to be withdrawn over the next 18m.
This process is clearly well under way in the US. We have seen no signal from US Fed policymakers in recent weeks of any deviation from the currently planned 3 rate increases for 2018. The most recent FOMC meeting statement this week remains consistent with this view. Indeed, should the dollar continue to fall this will only place upward pressure on US interest rate expectations.
Under these conditions of strong growth and tightening monetary policy, the stand-out mis-pricing for global markets at the start of 2018 was in our view the very low level of bond yields. The recent 20-30bps increases in global yields represents a correction closer to the current economic outlook in our view and the we believe yields are likely to move higher still as a the year progresses, provided growth momentum is maintained.
This increase in yields should not be a surprise for institutional investors as it was clearly a ‘known’ risk for 2018. Therefore, while higher bond yields may be a headwind for markets, unless the moves become disorderly, higher bond yields alone are unlikely to precipitate a major change in equity market sentiment. What would however change sentiment is the sense that the globally synchronised economic improvements seen over the last 12m are losing momentum. Evidence for this is very limited to date, although the German IFO expectations index has started falling from peak levels.
Growth momentum will however remain a key pressure point for investors during the year. In particular, by mid-year the impact of 2017’s US monetary tightening will become more evident. The recent policy trajectories of central banks may have been an exercise in gradualism but that does not mean the response of the economy will necessarily be smooth or linear. During past periods of monetary tightening an abrupt change in investor sentiment has been more typical and it makes us uncomfortable to see equity market sentiment in the US at record positive levels. We believe at currently high valuations for developed market equities, investors should tread cautiously in what remains a top-of-cycle environment, even if rising bond yields are more likely a headwind than a precursor to a crisis.