Why the markets are wobbling

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Stock markets suffer setbacks on a frequent basis and the tricky issue for investors is to distinguish the temporary wobbles from the more serious events like 2000–02 and 2007–09. In this author’s judgment, while nothing is certain, this market problem is more likely to be serious than any episode since the financial crisis.

So what is happening? At the time of writing (May 11), the S&P 500 had suffered a 16% loss in the year to date. The tech-heavy Nasdaq index had been hit even harder with a 25% decline. As a result, some popular funds have taken a battering. Shares in Scottish Mortgage, previously one of the best performing British investment trusts because of its tech exposure have fallen by around a half. As my old colleague John Authers has noted on Bloomberg, the ARK innovation fund was incredibly hot during the pandemic. At one point it had outperformed an equally-weighted version of the S&P by 300%; now all its outperformance over the last 5 years has vanished.

The root cause of this turmoil is the disappearance of the “Goldilocks economy”, the conditions that have been positive for equity markets for much of the past four decades. A Goldilocks economy is not too hot (so as to produce inflation) or too cold (so as to produce recession). The most immediate issue is higher inflation, which was 8.3% in the latest figures from the US and 7% (excluding housing costs) in the UK. Inflation is a double problem. It is not just that it erodes the real value of fixed income investments (bonds); it also leads central banks to take action which could send economies into recession.

The problem is most clear in the government bond market. At the time of writing, the 10-year Treasury bond index yields more than 3%, compared with less than 1% when the pandemic first began to break in March 2020. The bond yields also rose two percentage points before the bursting of the dotcom bubble, and slightly less than that as the US housing market reached its peak in 2006.

However, the 10-year bond yield was over 3% as recently as 2018 without a market smash. While higher government bond yields mean higher borrowing costs for corporations and homeowners, this effect is slow to feed through into the economy, given the prevalence of fixed rates.

What makes 2022 different from 2018 is the context. Ever since “Black Monday” in October 1987, when the Fed cut rates after the US market fell nearly 23% in a day, investors have counted on central banks to ride to the rescue if they falter. But with inflation so high, central banks may have to keep on pushing up interest rates, regardless of market setbacks.

And here is the kicker. One of the main bullish arguments for share prices in recent decades has been the low level of interest rates and bond yields. For a start, it means that bonds and cash are less appealing as an alternative to equities. But it is also used as an argument for higher valuations.

A dollar now is worth more to people than a dollar in a year’s time, or ten years’ time. After all, you could invest today’s dollar so it would be worth more in 12 months. But if interest rates are low, this issue matters less; future cashflows are worth relatively more than they are in an era of high rates. The value of equities depends on future cash streams in the form of dividends, buy-backs and so on. Low rates means that investors have valued those future cash streams more highly and pushed up the price of shares. This is most marked in the technology sector, where current profits are often low, but rapid future earnings growth is expected. In short, lower rates imply higher equity valuations.

To some commentators (including this one), this has always been a dodgy argument. It assumes that, as rates fall, your expectations of future profits growth will not change. But central banks usually cut rates when they worry about growth. Look at Japan where low rates have been accompanied by deflation, sluggish growth and a stock market that is below its 1989 level.
So why has the market stayed high in the US (and some other parts of the developed world)? The reason is that profits have been remarkably robust, even when growth has not lived up to expectations. This has been down to the quasi-monopoly position of some technology firms and the way that globalisation has kept the lid on wage costs.

Both those factors are now under threat. Some technology firms did remarkably well out of the pandemic (as more consumers shopped online) but are faltering as life returns to normal (Netflix, for example). Others face a more hostile political environment (particularly in China) as neither the right nor the left seem fond of them. And globalisation is under threat too, given US hostility to China, Brexit, and Russia’s invasion of Ukraine. Countries are thinking about securing supplies of essential goods domestically, or at least from friendly countries. That may mean higher costs for companies, and lower profits.

If, and it remains an if, higher short-term rates and bond yields combine with an environment that looks much less friendly for corporate profits, then the big market setback that some have expected could be on the way. So watch not just the inflation numbers and central bank policy statements, but what big companies are saying about the future.