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After a Long Period of Calm, Volatility Hits the Stock Market

By Jared Franz
Capital Group Economist

In some ways, the financial markets always perform something of a balancing act as they navigate between the economic growth needed to power corporate earnings and the type of overly rapid expansion that can trigger rising inflation and interest rates. For the past several years, the stock market has been driven by optimism over the former, as improving growth around the world boosted employment and stirred consumer spending. Recently, however, uneasiness about the latter has cropped up.

Quickening global growth has sparked worries about a concomitant pickup in inflation, which can dent the economy and stock market in several ways, including by prompting the Federal Reserve to raise interest rates more quickly than expected. These fears caused long-term bond yields to edge up in recent weeks, and they spilled into the stock market after a government report showed better-than-expected wage growth. That seemed to indicate that employers are stretching to attract workers after years of rising employment. Higher salaries could spur companies to charge more for their goods, potentially setting off a chain of rising consumer prices.

Such concerns are not at all unusual in the financial markets. But they jolted stock prices following the relative calm that permeated the investment world in recent years. The sudden volatility suggests that investors are coming to grips with the idea that the low-growth environment may be giving way to a stronger cycle with greater inflationary pressures.

Though volatility is likely to remain elevated in the near term, there are reasons for optimism. Stocks started the year at a frenzied and unsustainable pace, and throttling the euphoria is a necessary step in re-establishing market stability. Beyond that, the global economic landscape remains favorable. And even if rates climb, I still expect them to remain at moderate levels that can help to foster growth.

Good Economic News Can Create Bad Stock Market News

The global economy has become increasingly synchronized in the past year. But the flipside of robust growth is that central banks are also more likely to raise rates. Thus, even after 1.25% in Fed rate hikes since late 2015, the market believes the central bank may raise rates three or more times in 2018 and perhaps 2019. Already, the Bank of England has begun raising rates while the European Central Bank cuts its bond purchases in half this year. That raises the specter that the era of ultra-low interest rates, which has been instrumental in boosting economic growth and asset prices, may be winding down and forcing investors to re-evaluate expectations.

The U.S. Economic Engine Is Roaring

Though the U.S. has been in recovery since 2009, its economy continues to improve. After strong growth in the latter part of last year, markets expect a healthy dose of stimulus from the recently passed tax cuts.

The missing piece of the puzzle in recent years has been wage growth. That began to change last week. Alongside the 200,000 new jobs the U.S. added in January, wage growth accelerated 2.9% ― the fastest pace in eight years. While my base case for wage growth has been a gradual acceleration in 2018 and 2019, as labor market slack tightens and the economy approaches full employment, it seems the market has taken this as evidence that the economy is stronger than expected.

It also implies that inflation could be rising. It broke out of its mid-2017 range later in the year, with the consumer price index slightly exceeding the Fed’s 2% target by year-end.

Inflation Could Weigh on the Financial Markets

An uptick in inflation provides the Fed strong cover to make good on its rate hiking projections, which the market had been somewhat sanguine about. Investors had also been complacent about the impact of central bank tightening – until now. Goldman Sachs’s Financial Conditions Index (a measure that takes into account short-term bond yields, long-term corporate bond yields, the dollar exchange rate and equity prices) began to spike early this month after bottoming out in late January when financial conditions were at their easiest in more than a decade.

Beyond stocks, volatility has affected the fixed-income markets, where stronger-than-expected economic data in the past few weeks has pushed yields higher. The 10-year Treasury yield has climbed above 2.70%, a level not seen since the so-called “taper tantrum” following the Federal Reserve’s 2013 announcement that it was planning to reduce its bond-buying program.

However, bond yields still remain historically low. In my view, we won’t see another swing of this magnitude in the near term, but rates could approach 3% this year.

Where Stocks Go From Here

What does this re-evaluation mean for U.S. stock valuations? There is less room for cushion with valuations higher than normal; however, looking at earnings, there’s reasons to be constructive. Global consumers are spending, corporate balance sheets are relatively stable and the U.S. tax cuts passed late last year could support low double-digit earnings growth this year. Those factors may wane in 2019, but earnings could still grow modestly.

To be sure, the market still face hurdles. More-rigid financial conditions could temper investors’ enthusiasm, and further volatility could hinge on how much tighter conditions actually become. Rising political uncertainty in Washington has also dampened market sentiment in recent days. 

However, it’s important to remember that growth is ultimately positive for companies. The current equity pullback comes on the heels of a 30% advance since January 2016, and hopefully valuations are now more grounded in reality. Over the medium term, I expect stocks to continue to be supported by earnings that have been stronger for companies not just in the U.S., but also in Europe and Asia.

JASF

Jared Franz is an economist who joined Capital Group in 2015. He holds a PhD in economics from the University of Illinois and a bachelor’s degree from Northwestern.