The return of volatility on the financial markets

A cura di Banque de Luxemburg Investments

Volatility has returned to the financial markets. Three subjects which are currently bothering the financial markets (apart from the declarations and decisions of the American president) merit exploring in greater detail: growth, inflation and the Federal Reserve’s monetary policy, as well as the repercussions that some of the potential scenarios could have on different asset classes. First, you might wonder whether the growth and inflation dynamic has really changed? After all, only a few months ago, investors were worrying about the weakness of the global economy and the monetary authorities’ inability to achieve their inflation target. Now they seem to be afraid of ‘overstimulation’ of the US economy and an increase in inflation.

There is no doubt that the US economy has improved in recent months. The arguments in favour of further acceleration rest on an upturn in private investment following the tax reform (which cut corporation tax and also makes investing more attractive due to depreciation changes) and a surge in public spending. However, although the tax reform could boost private investment, the fact remains that the main driver of the American economy is consumer spending. Over the last two years, the increase in consumer spending has partly been financed by drawing on savings, such that the savings rate fell to 2.4% in December, its lowest rate since September 2005. In the past, a very low savings rate has been the prelude to weaker growth. Furthermore, the rise in interest rates (at a time of high debt) and the increase in the oil price are also likely to weigh on consumer spending. The weakness in retail sales in recent months is therefore not surprising.

Consumers are likely to increasingly feel the pinch from the Federal Reserve’s ongoing monetary tightening. The economist Irving Fisher produced a mathematical formula which states that the total stock of money (M) multiplied by the velocity of its circulation (V) is equal to prices (P) multiplied by transactions (T) and hence to nominal growth (MV = PT). Growth in the money supply is currently slowing and the velocity of its circulation has steadily declined since the financial crisis. This situation does not immediately suggest a sustainable increase in nominal growth, or even inflation. As regards inflation, it is interesting to note that since its low in July 2016, the United States 10-year Treasury yield has more than doubled (from 1.36% to 2.84%), whereas inflation has fallen, as measured by consumer prices excluding energy and food, or by the Federal Reserve’s preferred indicator, the PCE (personal consumption expenditures) deflator excluding energy and food. The result is an increase in real interest rates which, in an environment of generalised excess debt, could be detrimental to growth.

In conclusion, the idea that some 10 years after the crisis, the bases for a sustainable increase in the global economy have been laid seems to us to be unrealistic. On the contrary, the central banks’ monetary policies prevented a general overhaul of the economic situation, while the structural brakes on growth remain present – demography, productivity trends, historically high debt, imbalance between savings and investment, and social inequalities. What is more, the measures put in place by the US authorities in terms of immigration and trade are likely to reinforce these dampers all the more. Lastly, the economic recovery we have seen in recent years largely rests on an increase in the prices of financial assets and real estate, and a rebound in prices of raw materials, a rebound that could be dented by the slowdown in the Chinese economy.

Recent fears over inflation

The second important subject for investors concerns inflation. Recent fears over inflation were mainly fuelled by January’s job statistics in the United States showing a slight acceleration in average hourly earnings, with a 2.9% year-on-year increase. February’s figures, published at the beginning of March, reassured the market again with an average hourly wage increase of 2.6% (it is galling to note that both rise in January and fall in February– and hence the investment decisions prompted by these figures – can be explained by some questionable statistical adjustments). Regarding inflation, two questions prevail: – Will the wage rise gather pace? – Will companies be able to pass on potential wage rises to their customers by raising their prices? Looking at the first question, it is true that the unemployment rate in the United States has fallen considerably in recent years and could soon drop below the 4% threshold. In the past, such a low rate would effectively have put pressure on wages. However, since the financial crisis, the relationship between the unemployment rate and wage rises has become much less clear. One reason could be the fact that the decline in the unemployment rate is largely due to the decrease in the labour participation rate, but we do not currently know whether this fall in the participation rate is structural (corresponding for example to lifestyle choices) or cyclical. In the latter case, the potential labour not currently included in the statistics might return, thereby relieving pressure on the job market, even if the Trump government’s anti-immigration policy reduces the labour supply in the longer term. It is also worth noting that the trend towards mergers and acquisitions has substantially reduced the number of employers in many areas, leading to a decline in workers’ bargaining power. Turning to the second question, we should remember that many companies are operating in a highly competitive environment and that phenomena such as digitisation and e-commerce often generate downward price convergence.

Potential impact of envisaged scenarios on main asset classes In the end, the fundamentals regarding growth and inflation have not changed dramatically in our view. So there is no reason to think that the central banks will adopt monetary policies that are very different from those that have already been factored in. However, this does not mean a return to an environment identical to last year’s, which saw share prices rise without much volatility. Donald Trump’s protectionist and isolationist rhetoric could escalate ahead of the mid-term elections in November and thus reinforce investors’ aversion to risk. However, decisions regarding allocation between asset classes as well as within each asset class are not the same in such a scenario as in a scenario of rising inflation. That is why during the stock market correction between January, 26 and February, 8 that was triggered by fears of a rising inflation, bond prices also fell whereas during the correction that started in March and which seems triggered by fears of rising protectionism, this is not the case. The following graph shows an example of how a decision tree could look in this respect. It also gives our view on the impact that the envisaged scenarios could have on the main asset classes.

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