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From FOMO to FONGO?

Peter Warnes  |  06 Feb 2018Text size  Decrease  Increase  |  
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The following is a special piece from Peter Warnes on the recent market declines. While Peter's commentary is normally reserved for Premium Subscribers, we have made this piece available to our entire audience.

Peter's recent commentary in the Your Money Weekly newsletter and his 2018 Forecast have been invaluable to the informed investor given recent events. Sign-up for a free Premium Trial to read Peter's continuing coverage of global markets.

 

I wrote this piece over the weekend in preparation for this week's Overview. After the further rout in US markets overnight I thought it would be useful to get my thoughts out early. While the markets are lower my message is unchanged.

More will come in Thursday's Overview with a strategy on how to benefit as value starts emerging.

Last week US markets experienced their worst week for two years, and on Friday, the worst daily slide since Brexit.

The high-flying Dow Jones Industrial Average (DJIA) lost almost 1,100 points or 4.15 per cent over the week. The closely watched volatility index (VIX), which measures the expectation of volatility over the next 30 days or the comfort level of investors, jumped 50 per cent to 18, as record-high complacency levels shattered.

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The behaviour of converts to Passive Investment Evangelism could determine whether last week's sell-off morphs into a meltdown.

It will be very interesting to see if those alleged long-term investors in exchange-traded funds (ETFs) switch allegiances from the fear-of-missing-out mantra (FOMO) to a more anxious and protective fear-of-not-getting-out (FONGO).

Has the music stopped? Is the band exhausted? Will investors lock in profits or watch them evaporate should markets move lower? It will be very interesting to see whether any semblance of latent fear develops.

The sell-off in US equities coincided with the release of the January jobs report which revealed average weekly wages increased at an annual rate of 2.9 per cent, above the 2.6 per cent consensus and the fastest growth in almost nine years. The tightening labour market was finally working, pushing wages higher.

Wages growth and inflation are linked and both influence bond yields. The closely watched 10-year bond yield surged six basis points to 2.85 per cent and it seems that was enough for some investors to make the call to sell or at least trim.

But the 10-year bond yield has been on the move for some time, putting on 45 basis points in the first four weeks of 2018 alone. The message finally got through last Friday. Many investors appear relatively relaxed as a correction to the high-flying US markets has been long overdue. This is entirely possible, and the surge in bond yields may well take a breather.

However, there are significant reasons outside concerns over wages/inflation forces which can drive bond yields meaningfully higher and which will add increasing pressure to share price valuations and therefore equities markets.

Firstly, global central banks, led by the US Federal Reserve (the Fed) are moving from quantitative easing (QE) to quantitative tightening (QT). Monetary policy via the interest rate mechanism is being tightened--less accommodative.

This is a normal process in the economic cycle. But this time around there is an additional layer to the process due to the massive asset purchases undertaken by the central banks to reliquefy the global financial system in the aftermath of the GFC.

Some US$15 trillion has been outlaid and global central bank balance sheets are bloated with these assets, including government bonds and residential and commercial mortgage-backed securities. Over time, these balance sheets will be normalised.

The Fed is a few months into an estimated six-to-seven-year journey. The European Central Bank and the Bank of Japan are still expanding their respective balance sheets but are near the turning point. This normalisation process puts upward pressure on bond yields as yield securities are sold, without reference to interest rate policy.

Secondly, the Trump administration has unleashed a massive untimely and unfunded fiscal wave. The self-proclaimed "king of debt" Donald Trump, the President of the United States, will drive the US deficit into unknown territory.

In 2017, the US government borrowed US$519 billion. It is on track to borrow almost US$1 trillion in 2018 and Treasury forecasts borrowing over US$1 trillion in 2019 and over US$1.2 trillion in 2020.

The "borrowing" is forecast to suck over US$3 trillion from the financial system through the sales of US Treasuries. This is a head-on collision of major proportions with the Fed's normalisation process. Bond yields must move significantly higher with supply side influences of this magnitude. This is record borrowing in any non-recessionary period.

Should something go awry, with the federal funds rate range at 1.25 per cent to 1.50 per cent, the Fed has just five 25-point bullets in its monetary policy chamber. In mid-2006 the Fed raised the federal funds rate to 5.25 per cent to cool a housing bubble, which was being supported by sub-prime loans. By December 2008 the federal funds rate range was 0.00-0.25 per cent--the equivalent of 20 25-point bullets having been fired.

Then the QE asset purchase stimulus program followed, pushing the Fed's balance sheet to US$4.3 trillion. It currently stands at US$4.2 trillion--there is little room to move here. The Fed is almost defenceless should another crisis emerge in the financial system and with record debt everywhere it can happen.

Jerome Powell could well have been thrown the mother of all hospital passes by the President.

This is not a time to be brave. It is probably too early to go bargain hunting. There will probably be a relief rally, but more downside is likely to develop over the next few weeks/months.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is Morningstar's head of equities research.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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