Strategy blog: Market volatility
"If you can keep your head when all about you are losing theirs... then perhaps you haven't understood the situation"
- with apologies to Kipling
Daily movements of 3-4% in the big stock market indices are unsettling even to experienced investors, let alone to younger colleagues and clients. After Monday's rout, global (and US) stocks are now down more than 20% in USD terms from their turn-of-the-year highs, making this a "bear market".
But it is the volatility in bond markets that seems more unsettling. These are "safe havens" – they're not supposed to move around so much. To find a global bond index, and the 10-year US Treasury note – the reference bond for global capital markets – down by similar amounts from their (earlier) highs is very unusual.
Similarly, to see the short-term interest rates priced into money markets rise by roughly 50bp in a week – as has just happened with expected end-2022 US, EZ and UK rates – is remarkable.
"Bear markets" excite sub-editors, but don't actually signal anything of substance to investors: they are arbitrary lines drawn in the financial sand. But this recent volatility does seem to have a clear underlying driver – namely, the risks associated with inflation, interest rates and recession, that is, the business cycle. Such risks are serious, but ultimately familiar (in contrast, perhaps, to the unfamiliar geopolitical risks posed by the conflict in Ukraine).
These risks have re-emerged at a time when global bond and money markets have been spoiled by record low interest rates, the unexpected culmination of a 40-year decline in rates since the early 1980s. Bonds' sell-off follows a lengthy period in which they have seemed to many of us to have been defying economic gravity.
The last week's volatility follows confirmation from the European Central Bank (ECB) that it is indeed poised to start raising its policy rates from July, in a process that it recognises might involve some large increments (that is, rates may need to rise in 50bp stages at some point, just as they seem poised to do in the US).
Then on Friday we learned that headline US inflation had rebounded to a new high of 8.6% in May.
Pundits were quick to conclude that this proved that inflation was not "transitory" but permanent. It is still way too soon to say that. Some indicators of global inflation pressure, such as freight charges, may be rolling over. Wage growth, which will be the ultimate determinant of inflation "stickiness", has not yet accelerated to levels anywhere near those needed to make 8-9% inflation an ongoing trend (if productivity growth is around 1-2%, wages need to trend around 10% to make unit costs rise by 8-9%).
Our view remains that inflation will eventually settle in the 2-4% region – higher than central bank targets and the last quarter century's norm, but significantly lower than today. And when we unravel the patterns traced by the relative movements of conventional and inflation-linked bonds, we find that today's bond markets expect pretty much the same thing – and that the latest sell-off in bonds has been driven not by any new surge in inflation expectations, but instead by a collective rethink about the scale of monetary normalisation looming at the Fed, the ECB and the Bank of England. It is expected real interest rates, not inflation expectations, that have been rising of late.
Bigger real rates are likely needed to bolster monetary credibility, which has taken quite a knock as central banks have been so slow to wake up to inflationary risk – not so much that posed by higher oil prices, but the underlying risk posed by ultra-low policy rates in an increasingly fully-employed global economy. The history books will not be kind.
Rising real interest rates are bad for most investments: there are few hiding places. Conventional and inflation-linked bonds are obviously directly at risk; and even gold can struggle when real rates are rising, as we've seen this year. Stocks are hit of course both because their valuations are undermined, and because the higher rates can damage growth and profitability.
After such a long period of low rates, it is not possible to know how far interest rates now have to rise in order to establish a credible level for future long-term real rates. Nor can anyone be sure of the impact of those higher rates on the global economy. Confidence and conviction today are not credible.
But we have seen many interest rate cycles in the past, and many recessions, and the damage looming does not have to be large or lasting. With interest rates having lagged so far behind inflation recently, debt burdens have been falling, and real oil prices are (as we've noted) not that high.
The nominal stability of cash has had a lot going for it recently: even at today's inflation rates, consumer prices are less volatile than stock or bond prices. At some stage, however, the familiar risks will be priced in, and opportunities will present themselves.
Again, there can be no precise thresholds: a lot depends on the context and sequencing in which events now unfold (and as noted, Ukraine's ongoing trauma still presents more unfamiliar geopolitical risks – distinct from those posed by higher oil and food costs). Markets can of course undershoot "fair value".
Some bonds are starting to look interesting. At 3.3% the 10-year US note yield is beginning to offer a positive real return if, as we expect, inflation will settle around 2-4%. But we used to see 4-5% as a neutral level of yields in the US (and UK) market, and the peak in projected US policy rates is now approaching 4%.
Meanwhile, US stocks are now less than a standard deviation above their cyclically-adjusted PE trend, and we think they could live with bond yields at 4% (though it might take a while). The loss of even a full year's earnings (consistent with a big recession) might eliminate around 3% of their market value – a smaller hit than Monday.
Of the two big asset classes – bonds and stocks will always matter most to private client portfolios – stocks still look most likely to offer long-term returns ahead of that inflation.
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