After falls in stock market valuations is nervousness taking hold among investors? Looking at consecutive declines in global equities this week, the answer could well be ‘yes’. This could well be a ‘healthy’ correction after the all-time closing highs set by the Dow Jones and S&P 500 indices and the 10% rise in the MSCI AC World index so far this year.
Even in a situation where valuations look high, any decline requires a trigger. A look at how markets reacted to the latest economic indicators can us help to understand current investor thinking.
The US employment mystery
The monthly release of the US employment report is a major event for markets and this time, it contained a big upset. Job creation in April fell far short of market expectations for a million new jobs, coming out at only 266 000 after a downwardly revised 770 000 for March.
There is no obvious explanation for the shortfall in jobs. The ‘establishment survey’ that part of the report is based on is not renowned for its reliability. Or what was it a case of federal unemployment benefits (an additional USD 300 a week) discouraging workers from going back to work? Concerns over risk of infection with COVID at work and the difficulty of finding childcare while working might also have kept lower-paid employees from accepting job offers.
The US system of ‘temporary layoffs,’ which led to a sharp acceleration in job creation last summer when people simply returned to their jobs as companies reopened, may have hit its limits. People now need to go through the traditional recruitment processes which tend to slow the pace of hiring.
The number of long-term unemployed – those out of work for six months or longer, according to US criteria – has exceeded 4 million people since January. This compares with an average of 1.3 million in 2019. The mismatch between the supply of jobs and demand for work are beginning to come apparent.
Bad news can be good (and vice versa)
Encouraging progress in vaccination campaigns, evidence of vaccine effectiveness and the prospect of reopening economies are strengthening the case for a strong rebound in growth over the summer. Nonetheless, the possibility of accelerating inflation is increasingly becoming a concern for investors.
The latest uncertainty over the shape of the US labour market gave credibility to the Federal Reserve’s persistently accommodative stance and signalled to the equity market that policy rates will stay low for longer, supporting the scope for further gains. However, investors remain nervous over the potential for higher inflation and long-term market rates have begun to rise again.
A confluence of factors can be cited to explain these concerns: Higher commodity prices; a crippling attack on a US oil pipeline that could boost petrol prices; and an acceleration in Chinese producer prices to a 3-½ year high.
In Europe, German inflation came in at 2.1% year-on-year for April, exceeding the European Central Bank’s target for a second month and pointing in the direction of a rise to above 3% this year.
All this has given investors appetite for inflation-linked bonds. Markets see this development as a sign of growing expectations that the pace of inflation will accelerate, which in turn keeps the subject high on the agenda of concerns.
Yet, to date, central bank rhetoric has not changed: Upward pressure on inflation is seen as only temporary and linked to base effects and price normalisation in sectors where activity had been paralysed by the consequences of the pandemic. The European Commission’s spring forecasts are sounding equally benign: After 1.7% in 2021, eurozone inflation is expected to fall to 1.3% in 2022, while growth should be steady at 4.3% this year and 4.4% in 2022.
The upward pressure on long-term market interest rates over the last few days has been greater in the eurozone than in the US. This could be a reflection of the Federal Reserve’s monetary policy framework that allows it to tolerate (or even seek) inflation above its 2% objective for a while.
On 11 May, the yield on the German Bund abruptly rose to -0.16%, its highest since May 2019. By contrast, the yield on the comparable 10-year US T-note is now back at around 1.60% after rising to nearly 1.75% by the end of March. It is still below the levels seen at the beginning of 2020.
Outlook remains favourable
Our in-house ‘market temperature’ indicator on equities turned red in April, signalling a need for near-term caution and pointing to a less attractive risk/return ratio. These conditions have prevailed in recent weeks. Accordingly, the heightened risk of a pullback in equities has bolstered demand for hedging strategies.
Against this background, we expect markets to remain nervous in the short term, but given the breadth of supportive medium-term fundamentals, we see corrections as opportunities to add to equity exposure.
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