January was a month of two halves. Stronger economic performance extended the momentum behind equities at the start of the year, but this unwound over concerns that higher interest rates will have a negative impact on equity valuations.
After a couple of years of shock election and referendum results, and the growing threat of nuclear war, it wasn’t geopolitics that made investors nervous in the end, but signs of a strengthening economy in America.
Better-than-expected wage growth figures raised concerns among equity investors that interest rates could strengthen at a faster rate than originally pencilled in by experts. This view on interest rates accelerated a sell-off in bonds that had begun as yields rose in the tail-end of January.
Concerns over interest rates triggered the largest point drop in the history of the Dow Jones, which then rippled through global markets.
After 12 months of consecutive growth in the S&P 500 last year – a first for the US index – the S&P dropped around 7% from its peak, before recovering 2% in one trading session.
Granted the S&P’s graph doesn’t look too pretty, but the index is still 18% higher than it was this time last year and has grow 78% over the last five years.
It’s not timing the market but time in the market that maximises returns. A key study by asset manager JP Morgan highlights how damaging trying to time the market can be on your long-term returns.
If you had invested in the S&P 500 in the two decades to 2014 you’d have made just under 10% a year.
If you had missed the ten best days of performance by trying to time the market, this annualised return would have collapsed to 6.1%.
Why did economic data trigger an sell-off in equities?
Central Banks use inflation – the rate of price growth in an economy – to guide their monetary policy decisions.
If prices are rising too quickly and there are fears an economy could overheat, a Central Bank will increase interest rates to make borrowing/spending less attractive and saving more appealing.
Government bonds are generally regarded as a safer option in financial markets. If the yield (return) on risk-free assets increases, this could pressure on the price of other assets.
Inflation also impacts the value of future corporate profitability.
Equities are valued using a company’s future profits. Inflation reduces the future value of these profits. For example, if a company is expected to generate £100 of profit in one year and inflation is 1%, this profit is worth £99 in today’s money.
If inflation jumps to 3%, this £100 profit is worth just £97 in today’s money, and the price of the asset is likely to adjust to reflect this.
What does this mean for my investments?
Whenever you see signs of volatility pick up, it’s always tempting to ask whether it means something more.
This early-February sell-off is significant, but not because it forces us into a bear market, recession or financial crisis. It’s significant because it signals that markets are returning to normal after a very unusual 2017.
Last year’s record low levels of volatility on financial markets is not the historical norm and is unsustainable.
It’s important remember that volatility is a natural characteristic of the financial markets. It’s the rise and fall of the markets that allow investors to identify opportunities to buy an investment at a low price and sell it for more.
Volatility might have returned, but the underlying economic environment still looks strong, inflation is relatively low, and although Central Banks will tighten monetary policy, they will do so at a gradual pace – keeping a keen eye on maintaining the global economic recovery. Moneyfarm expects this to be reflected in asset prices.