Since last week, equity markets have erased most of 2018’s gains. Equities got off to too strong and too fast a start in January and some sentiment indicators became overoptimistic. The market sell-off is, nevertheless, more systematic than fundamental. Investors’ increasing fear of an end to the so-called Goldilocks environment is not justified and Candriam expects the supportive fundamental backdrop to prevail.
Since the end of last week, equity investors have been taking profit on their 2018 gains, initially because they feared the end of the Goldilocks environment, and especially an unexpected increase in US inflation. However, the real reason behind yesterday’s US equity market flash crash was a technical sell-off, not an inflation scare, as witnessed by the bond-yield decline during the equity sell-off. It was the result of systematic selling and the buying-back of large short positions on the volatility index (Vix).
A much stronger-than-expected expansion only a few weeks ago, renewed US dollar weakness and rising commodity prices are just some of the many reasons to fear the return of inflation. After nearly a decade of uninterrupted deflationary surprises, the consensus view of below-trend inflation is getting hit. Candriam agrees with the Fed that US inflation is likely to move up this year.
The US cycle is the most advanced on the global scale – as testified by the unemployment rate – and the tax reform has injected an additional stimulus, leading perceptions to shift rapidly. Since end-November, US 10y bond yields – led by rising inflation expectations – have risen sharply. Nevertheless, US real yields have remained extremely low, constituting strong support for the economy and for equities.
Candriam envisions three scenarios for 2018-2019 in the US:
The US bond market finally acknowledges that there is no recession around the corner and quickly adjusts towards the projected path of three Fed fund hikes this year and another three in 2019. To some extent, rising bond yields are more in sync with rising equity values. Looking forward, we expect further normalisation, but no overshooting, as the US 10y bond yield could reach 3% in 2018, as implied by the strength of the expansion.
The fiscal reform induces firms to invest durably more (+10% both in 2018 and 2019) and productivity revives strongly. In this context, inflation remains tame and the Fed sticks to its plan. Profits are boosted and the stock markets continue to rise. Long-term rates move higher, as the potential growth rate rises and does not induce a slowdown in the economy.
Markets suddenly believe the Fed is behind the curve and start to fear an upsurge in inflation: long-term interest rates move up significantly, triggering a decline in the stock market. This fear is mainly based on inflation expectations, rather than on actual inflation data.
However, outside the US, there are few signs of inflationary pressures. In particular, the situation is very different in the Euro zone, as inflation is likely to converge only very gradually towards the ECB’s 2% goal. The data published for the month of January confirmed the sluggish inflation trend, as the annual consumer price fell to 1.3% (core CPI at 1.0%). The upward movement in the currency over the past 12 months is easing tensions further.
There is no reason to question our fundamental scenario for the time being. Candriam still expects the Goldilocks environment to prevail throughout 2018 and fundamentals to remain supportive. Equities have become even more attractive following the recent correction. US equity markets are now trading at 17x 2018 earnings, while their forward price-earnings was still above 20x one week ago. In addition, strong earnings growth should remain supportive of equity market performance.
In this fundamentally sound market context, and although we might see a second wave of systematic sells, we are waiting for a stabilisation of market dynamics and looking for an attractive entry-point to further increase our equity exposure