Welcome to Authers’ Note, in which I will attempt to provide some context and analysis on the world of investment each day, and provide you with a handy guide to the best coverage on offer, both here in the FT and elsewhere. All feedback is welcome, particularly of the constructive variety, as we try to get this right. (Email to firstname.lastname@example.org).
Weeks like this one can addle the brain. To put it briefly in context, a good strong rally into the close today means that this is for now no more than a correction to the latest leg of exuberance that got under way about six months ago, once people began to grasp that a tax cut was a real possibility. We are not even back to that point, and it is intriguing how closely the rest of the world's stock markets have mirrored the action in the US:
This latest chart from Deutsche puts it in good perspective. Last year's lack of a correction looks like the aberration, not the belated appearance of a correction this week:
This week's correction is bang in line with the median biggest correction per year, going back to 1980.
What is more interesting is to probe whether this is really driven by bond yields and fears of inflation. Tom Porcelli of RBC put out an interesting note on this, and it is worth trying to answer some of his points.
Myth: Rising rates caused the sell-off
It’s amazing to us that the rise in yields is being used as a reason for the recent equity market rout. So let us see if we get this. The 10yr treasury yield sold off about 45 basis points in 2018 thus far, but it is the last 15 of these that presumably finally reined in the equity market rally? Was the equity market just whistling past the graveyard in January when it rallied a massive 7.5% even as 10s were selling off in non-trivial fashion from about 2.40% to 2.70%? Probably not. The rise in yields probably has nothing to do with the recent equity market roller-coaster. That is because on a real (inflation-adjusted) basis yields remain at extremely accommodative levels. The real yield for 10-year Treasuries is sitting at about 70 basis points, which is in the range that has been present for about 5 years now. And critically, it remains well below levels of policy tightening like the ones we witnessed back in 2006-2007 (near 3% real) when the Fed finalised its hiking campaign. So the argument that higher equity valuations can be justified by still ultra-low yields has not been invalidated by what 2018 has brought so far. In fact, 10-year Treasury yields need to approach 3.5% before we can even begin discussing the notion of monetary tightening.
I think he is overstating his case here. The correlation between stocks and bonds is not constant. At a certain point, the extra borrowing costs created by higher yields more than counterbalance the positive force for equity valuations that comes from the fact that they are growing. I think the widespread calls that the bond bull market was at last over played a major part in prompting a rethink about equities at a point when they were infeasibly expensive. If the economy is strong enough to create inflationary pressure from here, and require higher rates, then that will be bad for equity valuations.
That brings us to what is probably the central question. Do we really have an inflation problem? As the following chart shows, we do not as yet have one. And we do not as yet, at least by any market measure, expect one:
All that said, it is reasonable to be worried about inflation. The US economy appears to be in fine shape, and it has suddenly been given a huge tax cut. That will boost activity, and it will also cost a lot to finance — through higher bond yields. The mentality surrounding the tax cut, or the frame of reference people used when discussing it, turned through 180 degrees this week, it appeared to me.
Inflation will be the measure of whether we are really entering a new era. Next Wednesday, on Valentine's Day, we get CPI inflation numbers for the US. They will matter much more than usual.
Negative-yielding debt: fill your boots!
Here is a question. It is January 2017. You have a choice between two kinds of government debt. The first pays you a yield. The second charges you for holding it — its price is so high that you actually have to withstand a negative yield. Which should you buy if you want to generate a good return by this week, in February 2018?
Here is the answer, in astonishing graphical reform, from Bianco Research.
Yes, it transpires that you would have generated a higher return for yourself by paying a government to look after your money for you and forsaking any yield. It's a strange world we live in.
Friday's late rally stripped this sell-off of some of its historical significance. This was now merely the worst week for the S&P since January 2016. At its lows today, it was on course to be the worst since markets hit rock bottom after the crisis in early 2009. The markets do remain down, however.
Should we be disheartened? The Beatles introduced the world to the concept of the stadium concert a few miles from where I wrote this, more than 50 years ago now, and they seemed to be able to live with being down and still enjoy themselves:
So let's try to celebrate the fact that for this week at least stocks have been Going Down . . .
Indeed, a Long Way Down
From here, the only way is up (unless we go down). Have a good weekend.
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