The U.S. and global equity markets plunged in early February, with market participants concerned about a number of factors. What's driving the turbulence, and is it likely to continue?
The year began with a pronounced disconnect between economic growth (both realized and expected) and the bond market. The disconnect could not persist indefinitely.
Continued strong economic growth, however, suggests that current bond-market repricing and multiple compression in equities are nearing completion.
The bond market has been repricing growth. Long-term yields on U.S. bonds are up to 2.82% (and have been as high as 2.88%), some 30 basis points greater than they were in early January. There are no signs of trouble in the bond markets, no widening of corporate spreads—not even in high yield.
Because a 10-year yield of below 3.00% would be consistent with current growth and the near-term outlook, it is likely that we are nearing the end of the current correction in the bond market. In my opinion, it will last perhaps one to two more weeks, if that.
With growth now firm around the world, the market's attention has turned to signs of inflation. In a nutshell, I believe it is premature to worry about a meaningful acceleration in inflation from current levels.
In Europe, the expansion is still in early stages. For example, from peak to trough, Italy has lost 9% of gross domestic product (GDP) since the global financial crisis. So far, it has recovered only about 3.5%, so the output gap is still meaningful.
Spain, having grown by more than 3% for several years now only returned to pre-crisis GDP levels late last year. With the exception of Germany, every country in Europe is somewhere between Italy and Spain.
All labor-market reforms that have been introduced over the past several years (including 2017 in France) mean that the employment/inflation tradeoff is much more favorable now compared to a few years ago. That means Europe can grow for longer and employment growth can continue for longer from current levels before we see widespread wage pressures.
In the United States, the expansion is much more advanced. Hence, the talk of inflation is louder. At the same time, prices have remained benign. Hourly earnings growth has not yet accelerated meaningfully despite continued strong employment gains, and consumer price inflation is not showing signs of acceleration.
While the weak U.S. dollar points to some upward pressure on consumer prices, the United States is a fairly closed economy, so the pass-through is likely to be minimal.
The most surprising aspect of the unfolding correction has been the depreciation of the U.S. dollar. One reason is that larger U.S. current-account deficits mean more U.S. dollars flowing abroad. This improves U.S. dollar liquidity, but also depreciates the currency.
At the same time, U.S. Treasury issuance is expected to double from 2017 levels this year, and a larger fiscal deficit means more financing needs at a time when growth differentials make the United States marginally less attractive.
A Return to Fundamentals?
Continued strong economic growth suggests that current bond-market repricing and multiple compression in equities are nearing completion. So, in my opinion, we are likely to see a return to earnings trends and other fundamentals driving returns.