While regime change is an absolute certainty when considering the evolution of economic and equity cycles over the long term, the rise in volatility and fall in global equity markets in February has shown once again how much equity markets tend to react in the short term to points of change. In this case, with a decent sized tantrum.
The somewhat unusual trigger for the biggest single day point loss for the Dow was centred on a positive upside surprise for US wage data. While you might think indicators of the real economy getting better might be viewed as positive, clearly the prospect of inflation rising, temporarily, or more sustainably, got the market thinking more about life after QE and maybe life in a higher interest rate world. One way or another, change has once again shown itself to be a lot less loved than presumed certainty.
Like it or loathe it, we enjoyed an unusually stable and certain period in 2017. Change and evolution was always likely, with selling pressure the most obvious outcome. This is especially true with bears having sharpened their claws on the back of a 25% return for global equity markets in 2017. This has come on top of the monumental returns over the past nine years.
What are our observations on the correction? The catalyst for the correction seemed to be fundamental in origin, but quite technical in execution. However, we know and have felt sentiment rising a long way over the past year.
Given this, investors adjusting to new data around inflation ‘risk’, a rise in the VIX and a pull-back in markets is intuitively quite ‘normal’. Perhaps less normal was the speed and magnitude capital withdrew from markets, as a rising VIX index seemed to shock volatility-linked products into selling and rebalancing.
While no one knows the true extent to which market ownership has changed over the past few years, February’s pull back gives some indication portfolio insurance and target volatility products are meaningful market movers in way that was not the case in decades past. This perhaps indicates that while volatility has been low, inflection points will continue to be harsh and with the last meaningful risk off environment nearly two years ago, so it proved to be the case as the rush for the exit door unfolded in February.
The inflation cycle still appears modest
We remain relatively sceptical inflation will meaningfully and persistently rise. Our expectations for how much inflation may change from today’s muted levels have roots in the structural deflationary forces existing today. The secular impact of technology, globalisation and demographics upon inflation remain headwinds for a sustained rise in inflation. While these factors do not sit comfortably in economist models and are hard to measure, these influences are real and have been showing themselves in inflation data that should, all being equal, already be much higher.
So why is the market so concerned? The Fed has as we predicted started to talk much tougher around the upside risks to inflation, but we still believe that all else equal, the deflationary factors will mute the rise in prices over the next phase of this cycle, versus previous economic cycles that often govern policymakers and investment models.
While we remain open to change ourselves, we sense little appetite from corporates to embark on a sustained rise in wages. Given this and despite some of the tax cut gains being passed on near term, the inflation cycle still looks modest to us. However, February is a reminder that a slow shift in regime is important, as it will give markets, corporates and consumers time to adjust as interest rates begin to gradually rise.
A rise in inflation and tighter monetary policy certainly could be a risk to ‘goldilocks’, but one month’s data does not a trend make. We are likely to have a bumpier ride ahead, as a greater breadth of sentiment emerges on less universally positive data points. While challenging for investors that want to allocate capital to themes associated with obvious improvement, some injection of uncertainty feels normal as well as healthy. This is especially true for us as fundamental stock pickers who now get a chance to show our true skills and abilities in potentially more volatile markets.
Dave Eiswert is portfolio manager of the T. Rowe Price Global Focused Growth Equity Fund.
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