A welcome correction?

The past week has been a memorable one on global markets, but is it a signal of a new market paradigm or simply a welcome correction. Or perhaps even simply a technical accident?

Perhaps the best example to illustrate the different arguments is the S&P 500, the global equity bellwether, which was as it happens the market that triggered the rout. This market reached a record level of around 2,873 on January 26 and spent the next three trading days falling like a stone, until it reached 2,645 on Monday, whereupon it turned sharply and ended the Tuesday trading session at 2,645. Monday’s decline was the biggest points fall on record, but really that means nothing because the higher the market rises, the larger any given percentage fall (or rise) will be in points terms.

The argument that the decline was really a kind of technical accident lies in the fact that there was an abrupt surge on indices that track market volatility. The most famous of this is the Chicago Board Options Exchange volatility index, known by its trading symbol, the VIX. The gauge is known colloquially as the market fear index. The VIX has been low and stable for years, so traders betting on continued calm have profited in recent years.

The trade spectacularly unravelled over the past week, with several banks quickly exiting the market. That sparked a chain reaction, which spooked other markets including bonds and commodities. The VIX jumped in the process of this turmoil, measuring more than 50 at one point, and was trading more recently in the high 30s. The unwinding process in any market is difficult and the VIX is now so assiduously tracked it’s bound to be uncomfortable until all the bets against volatility are covered. So much for the technical accident argument. What about the “welcome correction” argument? To use the S&P as an example again, this market has risen more or less steadily for almost eight years from 680 to its currently value over 2,600. That is an incredible increase, even if you take into account that the low point was set by the financial crisis. The rise over the past year alone was over 20%. The increase took the value of the market as a whole to an average of about 24 times the annual earnings of its constituents. That is extremely expensive, even considering the tax cut for businesses introduced by US President Donald Trump. This week’s calamity has only wiped out the gains made in the first six weeks of the year. There is certainly nothing in expected global growth rates to justify a larger fall. And employment rates are very high, as is business confidence in the US and elsewhere.

In addition, if you look at the stocks that declined, they included both expensive and cheaper stocks, suggesting there is no real change in market sentiment. So, a welcome correction to an overvalued market.

The third option is that what we are seeing is the start of a much larger change, rooted in the return of inflation. Central banks around the world have spent the past eight years trying to encourage inflation to show some form of life — a task that is a historical oddity given that central banks are normally pushing the other direction. Inflation somehow disappeared from global finance for reasons that are complicated and multifaceted. Even dramatic central bank intervention in the form of quantitative easing has proved surprisingly ineffective.

There were, however, signs earlier this year that inflation might be gradually returning. Interest-rate yields on US 10-year government bonds rose solidly above 2.5% for the first time in almost a decade. They edged down this week from 2.8% to 2.7% but they remain high by recent standards. If inflation were to reappear, the effects would be dramatic.

Global stock markets have been benefiting from an implicit flow of easy money. The consequences of that being withdrawn are hard to fathom, but they are unlikely to be good — particularly for SA.