The sharp correction of the last two days is a reminder of how inherently unstable markets are. The trigger, a larger than expected increase in Average Hourly Earnings in the US, cannot itself explain such a violent gyration.
In fact, US Treasury yields have been steadily rising since the summer (see graph below), when macro data clearly evidenced a positive economic momentum globally. With all major economies running at or close to full potential, and little slack in the labor market, higher real interest rates were to be expected.
Overall, market observers have been circumscribing the problem of rising yields in the bond market, and have expected equities to continue performing positively on the back of earnings growth from a stronger economy. But you cannot have your cake and eat it, and if rates rise faster than earnings, a compression in P/E multiples becomes unavoidable.
However, none of this can explain the violence of the sell-off during the past few days. The explanation rather points towards a combination of technical factors (stop-losses, automated trades) behind the speed of the fall at the end of Monday’s trading session.
As we do not see any fundamental reason that would support a crash, we recommend to stay calm and take some time to assess whether the «goldilocks scenario» is dead and we are moving into reflationary territory, or if this is just a much needed correction whilst the market digests how to price in a higher interest rate environment.
Shortly after Alan Greenspan took over the reins at the Fed, he was confronted with the “Black Monday Crash”, when the Dow inexplicably dropped by 22.6%. Just getting off a plane, he released the following statement «The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system».
This helped to reassure markets and avoid an economic crisis. However, it gave birth to an era of investor dependency on central banks; something that has only worsened over the years. On Monday, Jerome Powell was sworn-in as the new Fed chairman, so it will be interesting to see his response to his first major “crisis”.
Dr. Fernando de Frutos
Chief Investment Officer, Boreal Capital Management AG
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