Investor sentiment had been extremely optimistic in recent months and markets have been overbought, but that is now no longer the case. After last weeks near-4% decline, the S&P 500 is now officially in correction territory, being down by more than 10% from its record high reached on 26 January. However, in the midst of this kind of market turbulence it’s particularly important to take a step back and consider the broader economic backdrop as global growth is still strong and inflation is still low.
Unemployment, personal income and industrial production are running stronger than their recent history and are accelerating away from the trend. It is this concept which forms the basis of the best barometers of where we are in the business cycle. It is suggested that the US economy is still in an expansion phase.
The recently reported stronger than expected US wage growth (2.9%) is getting the blame as the trigger for stock selling. Markets were spooked by speculation that the Federal Reserve (Fed) would raise interest rates faster than previously expected. But markets were overdue a correction, with valuations becoming stretched through successive record highs over the course of 2017 and into January. Wage inflation figures appear to have been merely the trigger.
Prior to this correction, volatility was both at record lows and well below where macro-economic and market indicators implied it should be. The sudden return of volatility appears likely to have exacerbated the selling, especially as a result of heavy losses among popular exchange-traded products designed for investors betting on continued calm. As these and similar bets continue to be unwound, the period of exceptionally low volatility is probably now behind us for a while. We are however still cautious over impact of future US Federal Funds interest rate rises ahead of those already expected and the ongoing unwinding of the Feds quantitative easing programme.
A pickup in wage growth should have been on the cards for a while, but this does not mean that there is a clear and directly linked relationship between wage inflation, price inflation and interest rate policy. The correlation between wages and inflation has been exceptionally weak, and the response of wages to low unemployment in the US has been tepid at best. Policymakers at the Fed have expressed more and more scepticism about the pass through from wages to inflation.
The surprise acceleration in wage growth wasn’t broad based either. Production and less senior staff didn’t enjoy the same up-lift. The inflation-adjusted wages of part-time workers, who account for almost one in five of the workforce, are falling. Wealthier earners are more likely to save extra income and so don’t present quite as much of an inflationary threat. Wage growth would have to shift up rather more dramatically to cause the Fed to put a squeeze on the business cycle this year.
The Fed has a mandate to maintain stable price inflation, and is most likely to respond to prices that it can actually do something about. Energy and food prices are beyond the control of any central bank and costs relating to housing can take an awfully long time to adjust. When we strip out these three sectors, US consumer price inflation is running at 0.7% which is actually low, not high.
While other economic growth indicators have been robust, some indicators of financial conditions have been sending a different signal. They have been not outright bearish, but definitely rather less bullish. The yield curve, which describes the yield differential between various long and short-dated US Treasuries, has narrowed or flattened. The narrowing in this proxy for the gap between return on capital and the cost of capital suggests slower growth ahead. The same is true for other monetary and credit indicators.
These indicators never suggested a recession was on the cards this year, and bear markets don’t tend to come without recessions. In fact, the yield curve has also stopped flattening, with 10-year yields rising 0.2 percentage points relative to 2-year yields, which is significant in this context, in the past week which is a good sign.
We’re confident that macroeconomic conditions will support equity market returns this year, but we are very conscious that the structure of US firms may have made them more sensitive to higher interest rates. There has been a dramatic rise in corporate borrowing: the median leverage of firms listed in the S&P 500 index is almost as high as it has ever been over the last 30 years.
Another factor contributing to our more cautious stance heading into 2018 was deterioration in earnings revisions. However 80% of US companies have beaten their fourth quarter earnings expectations, and upward revisions in the US have shot up in January as tax breaks recently passed into law made their way into forecasts.
We believe over complacency is probably the crucial factor in this correction. Equity market corrections greater than 10% are very rare during the expansion phase of the business cycle. The underlying economic data suggests that this time shouldn’t be any different. Of course, rising monetary policy is going to be difficult for markets to digest, given higher leverage. But we don’t see a real squeeze coming this year and if this correction has helped remove some complacency that may be a good thing.