Recently, after a very long run-up, equity markets underwent a spectacular about-face described by some as a healthy and long-overdue correction and by others as the first ominous sign of more upheaval to come. How worried should we be now that both stock and bond prices have been dropping in unison while earlier, when the recovery was on shakier ground, losses in one category tended to be offset by gains in the other?
In our view the reappearance of higher volatility and of this positive correlation is a welcome sign that financial markets are finally shaking off the aftershocks of the long period of financial repression1 in place since the Great Recession. Why is this happening now? Our interpretation is that financial markets, at times, gyrate far beyond what underlying changes to fundamentals appear to justify. Until recently, many central banks maintained interest rates at what can arguably be called artificially low levels. These artificially low rates, which prevailed for many years, also had the effect of repressing normal volatility in markets for risky assets. As an example, before the recent swoon, the U.S. equity market had increased by 34% since the U.S. presidential election without any setback of more than 2.8%. While volatility was uncharacteristically low, the market "narrative" became that growth and inflation are facing enough secular headwinds such that these low interest rates will from now on become the "new normal". Now, the question is: what has changed lately in the market narrative to unshackle this repressed volatility?
In our view, two catalysts have been interacting. The first is a broadening perception that both bonds and stocks are richly valued and that a correction of these lofty valuations is long overdue. The second is a growing consensus that global growth is stronger and broader than the earlier market narrative had it. This evolving story is that this better growth will no longer keep inflation repressed and these exceptionally accommodative monetary policies are no longer the right prescription.
Given this new narrative, should the resurgence of market volatility be interpreted as a sign that this better global growth will soon be choked off by rising interest rates? Fifty years ago already, Paul Samuelson, the famous Nobel-laureate economist, quipped that "the stock market has predicted nine of the last five recessions". His keen insight was that stock prices correct in anticipation of recessions but also have a dynamic of their own, where precipitous drops do not always portend an economic storm.
Ultimately, we believe that large changes in financial asset prices will occur as investors anticipate or respond to significant shifts in growth, inflation and monetary policy since they affect profits, the supply of liquidity and risk aversion. Our current reading is that growth prospects are still quite favourable, inflation is no longer depressed but is non-threatening so far and that monetary policy will continue to gradually return towards a neutral posture that neither supports nor restrains economic activity. In such an environment, opposing forces will generate more volatility than earlier as profits continue to grow but interest rates rise albeit at a moderate pace. This context continues to favour stock over bond returns. If inflation becomes more worrisome and incites central banks to step up the pace of rate hikes, then equities and economic growth would be vulnerable to more significant setbacks. Until then, expect typical market volatility to reassert itself as the long march of the world economy away from the Great Recession evolves into the longest economic cycle on record for the U.S. economy.
1Financial repression is characterized by interest rates that are maintained artificially low and that repress returns on savings.