William De Vijlder

Based on historical experience, the recent increase in equity volatility may end up weighing on future growth.

US long-term rates rose sharply in early October, which brings to mind the sudden rise in early February. Upside surprises in terms of wages and inflation triggered February’s upturn, while the catalyst in early October was a strong rise in non-manufacturing ISM, an indicator that is usually not monitored very closely. That this indicator should have such a big impact already shows how nervous the markets are.

In Wall Street stock market fell sharply again, pursuing a bearish trend initiated several weeks earlier. For an economic understanding of these trends, it is worth comparing equity market behaviour with that of the other asset classes, an exercise that is all the more difficult given that the correlation between asset classes tends to increase as pressures rise.

Equity markets continue to be particularly volatile. Understandably this has weighed on government bond yields. The volatility of high yield bonds remains low however. This could indicate that recent equity market swings are driven by other factors than worries about the outlook for GDP growth or monetary policy.

The eruption of US equity market volatility, with global spillover effects, is a delayed reaction to a rather significant increase in bond yields since the second part of August. Market-implied inflation expectations didn’t move that much so the rise in long term rates reflects an increase in real yields which in turn is related to strong growth numbers. Historically the relationship between weekly changes in yields and stock market performance is weak. This implies that one should focus on drivers of investor risk appetite and in particular signs of slower growth.

Judging by the recent developments in financial markets, investors feel more upbeat. On the economic front (growth and the outlook for monetary policy) nothing has really changed. The euro has benefitted from the ‘risk-on’ environment despite a widening interest rate differential with the US.

In the September 2018 edition of EcoTV week, William de Vijlder and François Doux discuss on the protectionist threat which has been grabbing headlines but hasn’t stopped Wall Street from reaching new highs, supported by growth in earnings and the perception of a dovish Fed.

Speculative positioning in VIX futures shows investors expect volatility to remain low, which implies an absence of growth or inflation shocks. The flattening of the US yield curve shows investors expect slower growth. These conflicting views may reflect differences in investment horizon but in the end, only one of the two can get it right, which is a source of concern.

Central bank communication has gone through a fundamental transformation in the past three decades.

Recent data have brought relief that strong US growth remains intact but eventually this is likely to produce concern about inflation overshooting the Fed’s target.

Political uncertainty in Italy has caused market turmoil with significant spillover effects within but also beyond the Eurozone. Contagion within the eurozone was of a different nature than in 2011. With a new government in place, attention will now focus on its economic policy, in particular in terms of public finances.

What keeps investment managers awake at night?

During the current business cycle, rising bond yields have been accompanied by rising equity prices. From a historical perspective, the rise in equities in recent months has been abnormally strong, probably helped by the prospect of corporate tax cuts. Market developments this week show a high sensitivity to economic surprises which may end up fuelling economic uncertainty.

The ECB’s Financial Stability Review expresses concern about increased risk-taking behaviour in financial markets. Such behaviour increases the sensitivity of markets to unexpected developments in the economy. Accommodative monetary policy is a balancing act when growth is robust, inflation low and asset valuations rich.

The slope of the US yield curve has flattened significantly this year despite Fed rate hikes. In the past this has often been a harbinger of a major economic downturn. In this cycle the signal coming from the yield curve has probably become less reliable.