GlobalFeb 6 2018

What is causing equity markets to wobble?

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What is causing equity markets to wobble?

The fall in equity markets in recent days is the result of bond yields moving higher, and the medium term outlook being unpredictable, according to David Jane, who runs £880m across three multi-asset funds at Miton.

The S&P 500 index is expected to open 1.2 per cent down today (6 February) and the Dow Jones Industrial Average 1.8 per cent lower.

Yesterday (5 February), the S&P 500 index ended the day 4.1 per cent down and the Dow dropped 4.6 per cent or 1,175 points — its steepest ever fall in points.

Mr Jane noted the sell-off was sparked by better than expected economic data and wage growth in the US.

This prompted the market to expect US interest rates to rise at a faster pace than was previously expected by many, as the central bank would put rates up to stop inflation becoming so high that it destabilised the economy.  

Mr Jane said such a scenario is self evidently bad news for bond investors, because higher interest rates push bond prices downwards.

This is because higher interest rates will mean companies and countries coming to the market with new bonds will have to offer a higher interest rate to reflect the higher interest rates offered by cash.

So those who own, and want to sell, existing bonds, will have to take a price lower than face value to make the existing bonds as attractive as those coming to the market.

By taking a lower price, they are pushing the yield upwards.

But Mr Jane said it is not as simple as saying that, because the fall in bond prices is happening because investors have become more optimistic about the economy, and that equities would perform well.

He said equities are suffering because higher bond yields mean higher borrowing costs for companies, and for investors who borrow to invest, while the returns available on equities become less attractive as bond yields rise, because the gap between the dividend an investor can receive from an equity, and interest payment on a low-risk asset such as cash, reduces as interest rates rise, so equities are less attractive.

He said the continued weak performance of the dollar is a positive for global growth.

Mr Jane said he is not going to take any rash action, and instead wait to see whether the current sell-off continues.

James Bateman, chief investment officer for multi-asset at Fidelity, said a fall of the kind we have seen in equity markets so far is not news in the context of history.

But he said the major impact for investors could be that technology companies under perform, while those parts of the equity market which have underperformed could do better.

This is because of the opportunity cost of only shares that don't pay a dividend.

Mr Jane noted that investors might have been willing to forgo the income of a regular dividend when inflation and bond yields were low, but as bond yields rise, technology companies become less attractive investments.

Peter Elston, chief investment officer at Seneca, has had zero capital invested in US shares for much of the past year precisely because he felt the equity market would start to underperform once US interest rates had been rising for a prolonged period of time.

David Coombs, who managed £766m in multi-asset funds at Rathbones, said: "In the early part of 1994, bond markets sold down aggressively as the Fed tightened rates surprisingly quickly to curb a rise in inflation.

"Equity markets followed suit, but as economic growth remained robust, they finished the year higher.   

"Although it is highly likely that this set back could well run on, as traders adjust positions and investors sit on the side-lines, there is nothing right now to suggest that this is any more than a response to over-stretched markets, where valuations in certain areas were looking strained.

"Providing growth and earnings continue to come through in the next few quarters, then markets should remain resilient and move ahead."

Darius McDermott, managing director at Chelsea Financial Services, said the fall in equity markets is healthy following a long upward trend.

David Scott, an adviser at Andrews Gynne in Leeds, said the rise in asset prices experienced in recent years has been the result of the volume of cash pumped into the system as a result of the quantitative easing policies pursued by the US central bank.

Higher interest rates mean this cash is effectively been taken out of asset markets, leading to a profound problem for investors.   

Nouriel Rubini, a US-based economist who predicted the global financial crisis of 2008, said the blame for the collapse lies with US President Donald Trump's recent tax cut.

He said: "Do an unsustainable/unfair tax cut in an economy close to full employment and at risk of overheating; so no wonder bond yields spike and stock markets wobble; and tightening of financial conditions, if continues, could slow down growth. No tax free lunch."

david.thorpe@ft.com