Between 26 January and 8 February 2018, the US stock market, as measured by the S&P 500 index, declined by over 10%, whilst the UK stock market, as measured by the FTSE 100 declined 7.5%.
Not surprisingly, market corrections are not new. A few years ago, equity markets suffered a major correction, but the circumstances were quite different to the one experienced in the last few weeks. The perceived problem in the earlier correction was not enough growth, with widespread fears that China was heading for a severe slowdown. Now investors worry about the prospect of too much growth and particularly stronger wage growth, leading to inflationary pressures and the prospect of interest rates and bond yields rising faster than expected.
Unexpectedly strong wage growth was the trigger for market fears of inflation. The latest non-farm payroll data showed unemployment remained at 4.1%, with average hourly earnings increasing from 2.5% to 2.9%, year-on-year. This sharp increase suggests a very tight labour market.
In December, US inflation, as measured by the Consumer Prices Index (CPI), rose 2.1%, year-on-year. This is the fastest increase in nearly a year. This was above market expectations of 1.9%. The higher than expected inflation has pushed US 10-year Treasury yields to a 4-year high, to above 2.9%.
In the first Federal Open Market Committee meeting of the year, US interest rates were left unchanged. The expectation remains that the Federal Reserve (Fed) will increase interest rates 3 times this year, though there are concerns that the new Fed Chair, Jerome Powell, will adopt a more aggressive interest rate strategy. Analysts expect another interest rate increase in March.
In the last quarter of 2017, firms listed on the S&P 500 index achieved earnings growth of 15%, year-on-year. Sales growth is also at the highest level since the 3rd quarter of 2011. The buoyant US economy and the prospect of tax cuts and fiscal stimulus measures should continue to support corporate earnings. US earnings on firms listed on the S&P 500 index are forecast to grow 19%, in 2018.
In the UK, the Bank of England (BoE) held monetary policy steady in February, with interest rates being maintained at 0.5%. There have also been no changes to the asset purchase programme.
The UK economy is now forecast to grow at 1.8% in 2018, which is an upward revision from 1.6% that was forecast in November. The upgrade in growth is largely due to the strength in the economic activity elsewhere in the world. The BoE noted that global growth is now at the strongest pace in seven years and this is supporting UK activity. Half of all the growth registered in 2017 was due to net trade.
Consumer spending is still expected to remain relatively subdued and investment modest, whilst Brexit uncertainty continues. In other words, though growth might be better for the average household, it might not feel like it.
The BoE has also conducted its annual review of the supply side of the economy and concluded that there is a lack of supply in the economy. Supply side economics relates to the labour market and productivity. Higher demand, coupled with a lack of economic supply, points to increased inflationary pressures.
Inflation, as measured by CPI, on an annual basis, was 3%, in December, and with growth, which is meagre by historical standards, still judged to be above trend, the BoE are becoming increasingly nervous that inflation will not return to its 2% target.
Prior to the BoE meeting, the market was expecting interest rates to rise by 75 basis points (bps) between now and 2020. However, an increase of 25 bps now seems likely, in May. Mark Carney, the Governor of the BoE, has reassured markets by stating that the peak in interest rates is still expected to be well below 5%, which, before the financial crisis, the UK had become accustomed to.
The Eurozone economy is continuing to perform strongly, with Gross Domestic Product up 2.7% in the 4th quarter of 2017, which is keeping pace with the US. This is encouraging and will be factored into the European Central Bank’s decision-making. However, inflation, as measured by CPI, within the Eurozone remains subdued and was only 1.3%, year-on-year, in January. This marks the lowest reading since July 2017.
The European Commission is forecasting economic expansion within the European Union of 2.3% in 2018, up from 2.1% predicted in November.
Japan’s economy is also performing strongly, and at the end of last year, expanded for the eighth quarter in a row. This marks Japan’s longest uninterrupted streak of growth since the booming economy of the late 1980s.
Not all the economic data is positive, in that Japan’s trade balance swung to a deficit of ¥943.4 billion in January, falling into the red for the first time in eight months after imports rose due largely to the higher cost of natural resources.
The Japanese government has reappointed Haruhiko Kuroda for a second term as the Governor of the Bank of Japan (BoJ). Haruhiko Kuroda has overseen a policy of ultra-aggressive monetary easing, adopting in January 2016 the BoJ’s first ever policy of negative interest rates, which is effectively charging lenders to deposit their cash with the central bank. Haruhiko Kuroda’s reappointment should be positive news for the Japanese economy and should maintain the existing economic policies.
In theory, the strength of the US economy and the prospect of higher interest rates should result in a strong US Dollar. However, one key feature of the global economy is the weakness of the US Dollar, which declined broadly during the course of 2017. This decline has accelerated in the first month of the year and has been helped by comments from US Secretary of the Treasury, Steven Mnuchin, that a weaker US Dollar would be good for the US economy.
The US Dollar is now near a 3-year low against the Euro, with €1 trading at $1.232. There is no clear reason why the US Dollar has been weak, although one potential reason could be the Chinese selling US Treasury bonds.
A weak US Dollar has boosted commodity prices, particularly industrial and precious metals. Emerging markets that have US denominated debt have also benefited from the weak US Dollar.
Although there are signs that inflationary pressures are building, the outlook for the global economy remains positive, which, of course, should be reflected in the global markets.
Investors must, of course, monitor the key risks to the global economy. The key risks include interest rates rising, which could have a detrimental impact on the economy, together with the prospect of Donald Trump introducing protectionist measures.