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Watch tremors don't develop into something much larger

Peter Warnes  |  16 Feb 2018Text size  Decrease  Increase  |  
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US inflation picked up in January to its fastest pace in five months. Headline CPI increased 0.5 per cent with the core up 0.3 per cent, above expectations of increases of 0.3 per cent and 0.2 per cent respectively. Year on year, headline CPI was up 2.1 per cent and core 1.8 per cent.

Markets initially reacted negatively but rallied to close well into the green. Bond yields surged to well above the levels that triggered the market correction on 2 February, the 10-year yield settling at 2.91 per cent. January retail sales fell 0.3 per cent against expectations of +0.2 per cent.

Markets have apparently forgotten about the recent past as risk-on and FOMO (fear of missing out) juices resurfaced.

In geological speak, foreshocks or tremors are sometimes a warning of pending danger. They are caused by the Earth's tectonic plates rubbing against each other, continued friction and ultimate breaking the cause of more damaging earthquakes.

Tremor-like movements have occurred on global stock markets since the US January jobs report on 2 February revealed annualised wages growth of 2.9 per cent. This was the highest in eight and a half years, and above expectations of 2.6 per cent, signalling a possible revival of inflationary pressures.

The revelation moved bond yields at the longer end of the curve (10-year and beyond) and into territory not seen for several years with the 10-year yield at 2.85 per cent. The 10-year yield is commonly referred to as the risk-free rate and dictates the discount factor used in equities valuations, the underlying reason equities markets are closely linked to bond yields.

The economic plates of tightening monetary policy and stimulatory fiscal policy are rubbing against each other and causing tremors but have not yet broken.

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While the speed of the sell-off in equities markets may have surprised, the magnitude, the market performance in the 13 months from 1 January 2017 to 30 January 2018, and the shake-out since 2 February must be put in perspective. Individual market performances have not been equal, and neither will the correction.

The recent action in US markets hardly registers compared with the performance of the 13 months to 30 January. But this is a false level of comfort. My advice--don't stand in the way of surging bond yields. A US 10-year yield of 3.5 per cent plus is a very real possibility later in the year.

 

Exhibit 1: Market movements from 1 January 2017

chart

Source: Morningstar

 

The surge of the US 10-year bond yield to 2.85 per cent seemed to trigger complacent equity investors into action. A somnolent, unprepared, and brazen volatility index (VIX) shook violently. These were foreshocks or tremors in the global financial markets.

Don't forget record US margin loans of US$650 billion at last count also hang like the sword of Damocles. The return of volatility and wild market swings will increase the anxiety of those with loans against equity and ETF positions.

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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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