A lot of investors are clearly baffled by the sharp correction that rocked stockmarkets in early February.
The question we need to ask is whether the turmoil, seen also in US and Asian stockmarkets in early April, demonstrates that markets are hopelessly irrational, panicking just when the real economy is finally showing tangible signs of recovery, when inflation has emerged from the danger zone, and barely a month after a phase of out-and-out market euphoria.
We would argue, rather, that the recent correction actually marks the beginning of a return to rational behaviour, however uncomfortable it may be to investors.
A look back a few years since the 2008 financial crisis may help clarify things.
This was a period of unprecedented intervention by central banks, as heavily indebted governments across the developed world claimed they were powerless to put their economies back in shape. The central bankers' response was to pump cash into the system, and through continuous, massive bond purchases, they pushed interest rates way down.
The resulting fall in government bond yields drove investors to seek higher returns elsewhere – driving a rally of historic proportions in the corporate bond and equity markets.
From 2013 to 2017, for example, the Eurostoxx 600 index gained more than 40 per cent, and yields on German government paper fell by a factor of four, plunging from 2 per cent to 0.5 per cent.
All the while, it didn’t matter much that economic growth was so feeble because of the promise by central bankers that endless cash injections would continue to buoy all asset prices.
And though it may seem counterintuitive, as long as those monetary policies had a lacklustre impact on the real economy, investors could be sure that the central banks would keep coming through – and that valuations would keep rising.
The right question to be asking at that point was what form the process of exiting those exceptional circumstances would take.
If this unconventional monetary policy ultimately failed – that is, if inflation and GDP growth plummeted – financial markets would be shaken by a major crisis of confidence. That negative outcome has not happened.
The other conceivable outcome was success – that economic growth and inflation would pick up as a result of the exceptional monetary stimulus.
But if and when that happened, it would be time to scrap those policies, following which interest rates would rise back to “normal” levels – and equities would accordingly reflect this normalisation. That is what we are witnessing today.
What we need to grasp is that the market rally of these past several years involved steering a course between a rock and a hard place.
The US Federal Reserve was able to stop buying bonds in October 2014 without seriously roiling bond or stockmarkets.