Market volatility – voting machines and weighing machines
Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.
Last week’s data print showing hourly US wages rising faster than expected caused US Treasury yields to rise and the inflation outlook to be reappraised. This week, equity investors spied higher borrowing costs and demanded a higher risk premium (compensation for taking extra risk). Markets promptly sold off.
We know from prior experience that asset markets (housing as well as stock markets) react to changes in economic news and monetary and fiscal policy changes, whereas consumers react to changes in asset market values (house prices, share prices). The link between asset markets and consumers has been studied by many economists not least Alan Greenspan who was Chairman of the Federal Reserve during the TMT (Technology Media and Telecoms) bubble which burst in 2000.
The lead up to this point began with the Fed lowering interest rates after the market crash in 1987. They were lowered again whenever new and potentially destabilising market events were thought to pose risks to economic growth. This action of lowering rates to avert damage to the economy was known as the Greenspan ‘put’ (a put option is a derivative strategy for curtailing losses as markets fall). As economic growth accelerated and stock markets boomed Greenspan eventually put on the brakes while at the same time lamenting stock market ‘irrational exuberance’ that many believe he helped to create.
The link between stock markets and the real economy (the production of goods and services) is described by Benjamin Graham, mentor to Warren Buffett. He allegedly described it as follows, “stock markets are like voting machines in the short run but act as weighing machines in the long run”. In this context it is thought he meant that “voting” represented investors speculatively buying and selling stocks based on feelings such as fear and greed whereas long term investors would, instead, gauge or ‘weigh’ the potential for profits and economic growth.
We have to distinguish between what is a change in value, and what is just a change in price driven by short term speculation.
Concern over changes in the general level of prices being prompted by wage growth has happened before. If you look at the chart below, focusing on the period after the credit crisis in 2008/09, you can see that US inflation expectations (note: what investors expected) collapsed quite quickly in response to the financial turmoil underway at that time. US wages however, took longer to react and fell with a lag.
In the intervening period, since the global financial crisis, inflation expectations have ebbed and flowed whereas wage growth has remained stable, but highly subdued. Some think wages in the US are in a latent phase. Proponents of the Phillips curve (which describes the inverse relationship between wage inflation and unemployment) have scratched their collective heads as unemployment has fallen to historic lows without causing wages to pick up in any meaningful way. One imagines that they are now more confident in their belief that with low unemployment and accelerating economic growth wages will continue to rise and cause inflation expectations to shift upwards. If so this will cause interest rates to rise further and borrowing to become more costly.
Wage Growth and Inflation Expectation
Source: Bloomberg, 08 February 2018
So where are we now
First, the facts. The global economy is once again firing on all cylinders with the major economies of the world all enjoying a period of synchronised global growth (evident by the chart below).
Real GDP Growth (2018-19 Forecast)
Source: Bloomberg, 07 February 2018
Getting to the point where growth is self-sustaining, without the need for massive injections of money by central banks, has been challenging, but desirable. Central bankers are now at the stage of being able to wean the economy off emergency measures put in place such as QE (quantitative easing). The revival has been gradual and at times faltering making central banks ultra cautious not to choke off any recovery prematurely – a version of the Greenspan put.
Most economists accept that with economic prosperity must come a “normalisation” of monetary policy. Interest rates in the US have already begun to rise from the emergency levels introduced in 2009 and while the pace of change and the ultimate level to be reached to control inflation are both unknown the direction of travel is set. The return to wage growth is an early sign of normal relationships being re-established i.e. higher wage growth = higher consumer spending = higher prices = higher borrowing costs.
For markets the transition is unsettling. However, rising interest rates are a natural consequence of a prosperous economic outlook.
What does the future hold?
Global economic growth remains strong. The International Monetary Fund identifies this period as the strongest period for synchronised global growth in over a decade. Economies around the globe are supported by low unemployment and rising business confidence. Monetary policy, despite the gradual tightening process in place in the US and UK remains ‘loose’, meanwhile Europe and Japan continue to inject capital into their respective economies.
New fiscal stimulus measures of lower US corporate tax rates may be accompanied by businesses rewarding labour with higher wages and eschewing financial engineering (for example share buy backs) in favour of investing in new research and development, replacing old plant and equipment and introducing new innovative processes.
Yes, we are seeing interest rate and inflation expectations changing but this is to be expected. It is a good sign but not without consequences. Old-style businesses will get swept aside in favour of new ones. Flaky financial schemes and scams for the unwary investor will get found out in an environment of rising interest rates. This happens every cycle, hence greater price volatility seems likely. Capitalism is, and always will be, a creative destructive process that generates wealth over the long term.