“Tell me what’s going on,” sang Marvin Gaye. Investors might well ask the same question. Part of the answer is that market turmoil is consistent with risk reduction after a long bull run.
Markets that have risen furthest have been hit hardest. In developed markets, European equities have fared worse than the US, reflecting their bigger rally since the 2003 trough and lower levels of market liquidity. Emerging markets have been at the forefront of the sell-off – which has affected both countries with current account problems, such as Turkey, and those without, such as Brazil. This suggests that investors are unwinding popular trades – differentiation on the basis of economic fundamentals will come later. Rising correlation between previously unrelated markets and derivatives activity may also have made the correction more severe.
What triggered this? It would be convenient to blame rising inflationary pressures. After all, the release of US consumer price inflation data for April prompted a sharp fall in equities. But two consecutive monthly increases of 0.3 per cent in core CPI hardly constitute a full-blown inflation scare. Both gold prices and yields on US 10-year government bonds have fallen since May 12. US bonds have not markedly underperformed their European counterparts. Admittedly, flows into US Treasuries might be benefiting from a flight to quality, as riskier positions are closed out but the pattern does not fit an inflation scare in the pure sense.
More plausible is that investors are concerned that the trade-off between growth and inflation has deteriorated. Belief in the “Goldilocks” scenario – that global growth is strong but not sufficiently robust to lead to widespread inflation – may be waning. Investors are fretting that the Federal Reserve might seek to bolster its credibility and overreact to an uptick in inflation, hurting growth. The fact that equities have suffered rather than bonds, with commodity prices also falling, is consistent with a growth scare.
Has the correction further to run? With the Fed, the European Central Bank and the Bank of Japan all tightening liquidity, a lot of carry trades have been unwound. The near 10 per cent appreciation of the yen between mid-April and mid-May no doubt prompted investors to rethink trades funded in yen, while problems in Iceland, for example, predated the main market sell-off. It is difficult to say if this process is complete. A mindset among some investors that this is just another swift correction, which presents a buying opportunity, suggests it is not. Bullish investors have not capitulated. For volatility to subside investors need reassurance that this does not herald a sustained bear market. This requires the economic data to show that Goldilocks is still on track and evidence that the Fed has not lost its touch. Both are uncertain and will take time to play out. Expect further turmoil.
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