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Financial markets could be heading for a bumpy ride

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Financial markets have got a dose of the wobbles, with a big drop in Wall Street late on Friday hitting Asian markets and leading to weak trading in Europe on Monday. Last year was an exceptionally calm one on financial markets, but 2018 looks like it might be more volatile.

At the heart of this is uncertainty about the pick up in inflation and global interest rates – rock bottom borrowing costs have underpinned share markets for the last few years and are now slowly coming to an end. Central banks worldwide are at various stages of unwinding the monetary stimulus they injected during the economic crash and the process of “normalisation” is causing frayed nerves.Nobody is quite sure how it will all play out.

Trigger
The trigger for Friday’s fall were US figures published on Friday, showing annual wage growth of 2.9 per cent, the highest in a decade. As this was an indicator that inflation was picking up, it led to a rise in the key US 10-year interest rate – which amticpates future inflation – now trading well over 2.8 per cent.

Higher long-term interest rates increase the cost of funding for companies and also provide investors with more attractive options in the bond market, which competes for their cash with equities. So US equities, which are already trading at strong valuations, took a hammering on Friday, with the Dow Jones index of leading share down 2.5 per cent and the wider S&P 500 losing over 2 per cent, its biggest drop since September 2016.

It was a significant fall, if not an enormous one – big moves have been rare over the past year or so as market volatility was remarkably low amid a bull market with the S&P gaining 20 per cent least year.

The fall in interest rates during the crisis was unprecedented and provided equity markets with a big boost. After all, if the return on investing in Government bonds was tiny – or in some cases even negative – then the return on equities looked attractive. US interest rates have been on the way up for some time and the ten year rate has risen from 1.5 per cent in mid 2016 to over 2.8 per cent now. Europe is behind in the cycle and the ECB is still grappling with when to stop buying bonds to stimulate activity. But European growth is picking up too with higher short-term interest rates to follow, maybe next year.

Expectations
Government bond markets – which reflect expectations of where interest rates will be in the future – are already starting to anticipate further official rate rises by central banks. And there are some worries about the speed they may happen, or the impact of this on growth,corporate profits and investment trends.

As often happens in the markets, the wage growth figures did not lead to any fundamental change in expectations. Most investors expect three more 0.25 percentage point interest rate rises from the US Federal Reserve Board this year as the Fed has guided itself – or four at most. But the figures did seem to bring an accumulation of worries to the fore – about inflation, about the change of chair at the Fed and about the possible impact of recent US tax reforms on the budget deficit. And history teaches us that bond markets in particular can move quickly once a trend sets in, even if bonds have found a bit of support on Monday morning from buyers.

The backdrop is that financial markets are already at high valuations. As the outgoing Fed chair, Janet Yellen, pointed out on Friday when asked about US stock valuations: “ Well, I don’t want to say too high. But I do want to say high. Price-earnings ratios (a key measure of share valuations) are near the high end of their historical ranges.”

So what should we watch in the days ahead – apart from share prices of course. Perhaps the key is the US 10-year interest rates. Were it to move over 3 per cent, it would fray nerves further. Central banks had to press the panic button during the crisis, but taking away the sweetie jar of monetary stimulus is far from straightforward.

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