By: Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist), Old Mutual Multi-Managers
Global equity markets had a strong start to the year, but suddenly, almost out of nowhere, the wheels fell off. The sharp sell-off on the first three trading days of February resumed on Thursday. The MSCI All Countries World Index lost 7.5% in US dollar terms since the start of the month (although the return over 12 months is still 14%). This raises a number of important questions:
Interest rate worries
Firstly, what caused the sell-off? The jitters on equity markets were caused by rising bond yields. Bond markets priced in higher interest rates due to stronger economic growth in the US, Europe and elsewhere. Through January, equities rose in tandem with bond yields, but the trigger for the equity slump was last Friday’s US employment report. It showed that wage growth had jumped to 2.9%, the fastest pace since 2009 (although not a historically high rate).
Central banks, including the US Federal Reserve, place great weight on the Phillips Curve – the idea that rising wage growth will translate into higher inflation. Hence the market worries that the Federal Reserve will now hike interest rates faster than expected. However, the evidence that wage growth causes inflation is ambiguous and central banks are still likely to proceed gradually and carefully in removing the post-financial crisis emergency stimulus.
In fact, the Fed will welcome faster wage growth as it is also a sign of a healthy labour market. They wanted to achieve wage growth and inflation and it seems unlikely that they will overreact when it materialises. Rather than causing panic among Fed officials that the economy is overheating and rates need to be jacked up quickly, it should provide comfort that the era of ultra-low rates has achieved some success and that they can continue to gently raise interest rates to more normal levels. It’s important to remember that interest rates are rising for the right reason, namely that economic growth has picked up, and not because of runaway inflation.
The return of volatility
The sell-off seems to have been exacerbated by the unwinding of trades betting on low volatility. The market rally of the past few years occurred with historically low volatility. Throughout 2017, there was not a single day when the S&P500 lost 3% or more, and the CBOE Volatility Index (VIX), a measure of implied volatility on the US equity market, fell to a record low level by the start of the year. Volatility in other asset classes has also been historically low. In the process, volatility went from a by-product of market conditions to an asset class in itself, with a range of strategies, some of them geared, betting on low volatility and driving it lower in the process.
This included new-fangled products sold to unsuspecting retail investors who suffered huge losses last week. One exchange traded note that moved in the opposite direction to the VIX enjoyed a 600% return between January 2016 and 2018. However, it plunged 95% in February and had to be shut down when the VIX jumped from 10 to 37. The return of volatility will shake off some of the excesses and is therefore not entirely a bad thing. However, it’s not pleasant.
Do the wild market moves tell us anything about the state of the world economy and could it impact economic activity? In the midst of the market turmoil, the latest ISM Index, one of the most up-to-date economic indicators from the US economy, showed very healthy levels of activity in manufacturing and services. So the market is not expressing concern over falling growth or even deflation (as the big corrections in 2015 and early 2016 did), but rather over rising interest rates. Economic fundamentals remain solid and this means companies can still grow profits, which is what long-term investors should care about.
The buoyant global economy in turn is unlikely to be impacted by market volatility. Financial market volatility can impact real economic activity mainly through three channels: credit, wealth effects and exchange rate fluctuations.
In a banking crisis, as we saw in 2008, banks freeze provision to households and firms, and even call in loans, which severely curtails production and trade. There is no sign of stress in the banking system yet, nor in the corporate bond market. A wealth effect is when consumers feel richer or poorer and adjust spending accordingly. Gains in equity markets have been wiped out for this year, but at the end of December, US household net wealth was at a record high level relative to income. Finally, massive exchange rate movements can cause havoc, as South Africans know only too well. But there hasn’t been a huge surge in the dollar as was the case in 2008.
The impact on local markets
How has global volatility spilled over to local markets? Local bond yields have not followed global bond yields higher since the start of the year. (In other words, spreads have narrowed.) This is partly related to renewed optimism of political and economic reform, but other emerging markets have also seen spreads tighten.
However, the local equity market had a tough time. Apart from being impacted by the shift in global investor sentiment, the JSE has also been affected by a number of stock-specific issues over the past two months. These include the Steinhoff collapse in December, the short-seller’s negative report on Capitec and a similar loss in confidence in the Resilient stable of companies. The share price of Naspers, the largest on the JSE, has also declined 12% this year, despite the fact that the share price of Tencent is flat. The stronger rand over this period has also weighed on rand hedges, particularly in December.
Lessons from this episode
Finally, what lessons can investors learn from this episode? The US still matters most. The sell-off started in the US and then spread across the world from there. As riveting (and frustrating) as our local politics are, investors need to keep an eye on what happens in America.
Markets often shoot first and ask questions later. The sell-off was triggered by a single data point on wage growth from a month when the labour market was influenced by a heavy storm across the north-eastern US. This could be revised away in future and is therefore hardly a convincing sign of inflation.
To never be a forced seller of assets is a huge advantage as highly-geared investors are often forced to sell as asset values fall below outstanding loan values. When the squeeze is on, these traders sell what they can, not what they would prefer. On the other hand, long-term investors in simple but sturdy products like balanced funds don’t have to respond to such market moves and can just sit tight. If anything, volatility creates opportunities to pick up a few bargains. A related point is to avoid investments that you don’t understand even though they might have enjoyed stellar returns. This includes the short-term volatility products and cryptocurrencies. (Bitcoin has halved since the start of the year.)
Over the long term, corrections such as those of the past weeks don’t meaningfully influence returns, but investors’ reactions to them do. As Jason Zweig wrote in the Wall Street Journal last week: “The stock market didn’t get tested – you did.”
Chart 1: The return of volatility
Chart 2: S&P500 and FTSE/JSE All Share equity indices