Research Team, 10 January 2018

You may have noticed that markets have seen a modest pullback recently, sending shockwaves through the financial world. Although this has been scary for investors, to some extent there are some logical reasons behind the fall. We should also note that the damage has been limited, although further weakness can’t be ruled out.

Here are some of the key reasons behind the volatility:

1. Markets have run hard. Sharemarkets have had a phenomenal run, with the S&P 500 rising more than 35% since the beginning of November 2016 (even before dividends are accounted for). The blue chip Dow Jones index was within cooee of rising 10,000 points during the same period, an incredible feat.
There have been a number of solid reasons for these gains, but it is undeniable that the rally has been long and strong, and valuations have become stretched. Many strategists and commentators have been looking for a correction, defined as a fall of 10-20%, for some time now and this may have been the start of one. It is impossible to say whether we will see further weakness, how far it will go or how long it will last.

2. Selling leads to more selling. Some of the volatility can be attributed to nervous investors seeing prices falling and running for the hills, which has led to more selling. In addition, many funds these days use computer driven trading, based on algorithms and mathematical models. This is thought to have accentuated the sharp moves we have seen (in both directions).

3. Inflation expectations are rising. A key catalyst for the sell-off was the release of the January non-farm payroll data in the US. This pointed to a stronger than expected job market, with 200,000 jobs added during the month and the unemployment rate remaining at 4.1%. However, it was the wage data that really got people’s attention. Average hourly earnings rose 2.9% an annualised basis, the fastest since June 2009. This added to speculation that inflationary pressures are mounting, which means interest rates could rise more quickly than previously thought.

4. Interest rates are heading higher. Since the global financial crisis, central banks across the globe have undertaken substantial monetary policy easing. In addition to near-zero interest rates, many resorted to quantitative easing to evade deflationary pressures and boost activity. We are now coming out the other side of this period, and central banks are starting to step away from this ultra-loose monetary policy. The US Federal Reserve is leading the charge on this front, having increased interest rates four times since embarking on a tightening cycle. The Fed is expected to raise rates another three or four times this year as well. As interest rates rise, the allure of shares (and property, for that matter) reduces, as investors see improving returns in bond markets due to higher interest rates. This can lead to a selling pressure across sharemarkets.

5. Buy the rumour, sell the fact. We are in the middle of the global reporting season for the last quarter of 2017. This is shaping up as the third consecutive quarter of double-digit earnings growth for the S&P 500, with all sectors expected to see earnings and revenue growth. This has without doubt driven markets higher, although sharemarket lore suggests that investors often “buy the rumour and sell the fact”. This means we often see share prices perform well ahead of strong results, as investors anticipate the looming good news. However, once the company reports the good news is already “in the price” so we sometimes see selling pressure emerge. Another example of this is the recently announced tax reform. President Trump has promised since he started campaigning, which has added to the momentum across the market as the legislation drew closer. These reforms came into law in the New Year, and now appear largely factored into the prices investors have been willing to pay.

The five reasons mentioned above might sound gloomy at first, but they actually point to a number of positives.

Firstly, global economic activity looks robust and in particular, the US economy is in good shape. There would be no talk of interest rate hikes and inflation showing signs of life, nor would unemployment be at such low levels if the economy was on shaky ground.

The volatility we have seen over recent days has not been driven by fears of an economic hiccup, and we see no looming signs of recession to be wary of.

Secondly, global corporate earnings growth has been very impressive. The annual increase in earnings for the S&P 500 this quarter is currently sitting at over 13%, the strongest we have seen in almost seven years. For the first time since the third quarter of 2011, every market sector is forecast to see earnings and revenue grow.

Thirdly, long-term investors should welcome periods of weakness like this, rather than fear them. After an exceptional run it has been difficult to find value across markets, so many investors have been hoping for a decent sell-off to open up some buying opportunities.

Where markets will go over the short-term, we can only speculate. The US has had a rocky week and the CBOE volatility index has climbed higher than it has been all year. With the S&P 500 down 6.7% from its January closing high, the US market not in correction territory yet. It would need to fall another 3.6% to reach those levels.

On the plus side for investors in the local market, the NZX 50 hasn’t seen quite as much volatility as our global peers, having declined approximately 3.0% from the peak in early 2018.