The deflationary theme in financial markets was overdue for correction
EVERYONE wants to spot the moment when markets change trend. By riding one of the great bull markets—the rally in equities from 1982 onwards, for example—or avoiding a crippling bear market like that of 2007-08, fortunes can be made, or saved. The key lies in spotting the turning-point.
Commentators see several potential turning-points in today’s markets. The first is in government bonds. The ten-year American Treasury bond yield bottomed at 1.37% on July 7th and has since risen to 1.80%. The ten-year German bond yield reached a low of -0.18% on around the same date and has since edged back into positive territory, at 0.13%. British bond yields of the same maturity have shown an even sharper shift, rising from 0.61% to 1.17% thanks to worries about the economic impact of Brexit.
These yields are still very low by historical standards. But there has been a revival of talk that the long downward march of bond yields (and upward march of bond prices) dating back to 1982 may at last have reached an end.
A second turning-point may already have occurred, earlier in the year. Risky assets seem to have recovered in unison, with emerging-market equities, speculative or “junk” bonds, commodities and American property funds all reversing their poor performances of 2015 (see chart). David Ranson of HCWE, a research firm, says the trigger for the turnaround was the rally in the price of gold, which suffered its latest low at the end of 2015 and has rebounded by 20% this year.
The start of 2016 was marked by nervousness about the Chinese economy, the speed of monetary tightening in America and the risks of deflation. But China’s economy has continued to grow and the Federal Reserve has yet to push up interest rates again after its first increase in December 2015 (it may raise rates again next month). Deflation fears seem to have receded a bit. Gavyn Davies of Fulcrum Asset Management says that the headline inflation rate in advanced economies has risen from zero at one stage last year to 0.5%, and may reach 1.5% next year.
So one possible explanation for the market shifts is a perception that this is now a reflationary, not a deflationary, era. Gold has pulled out of a precipitate bear market; it fell by 44% between September 2011 and the end of last year. Perhaps its rebound is a sign that gold bugs’ worst fears about inflation and depreciating paper currencies are coming true at last.
Maybe. But Mr Davies points out that the pickup in headline inflation is largely the result of the rebound in commodity prices. Core inflation remains stuck in a narrow 1-1.2% range and seems likely to stay there. This is hardly a sign that we are heading for Weimar Germany-style hyperinflation.
More plausible, perhaps, is the idea that financial markets had overdone the deflationary fears.
Bank of America Merrill Lynch has compiled data on financial assets (equities and government bonds) and real assets (commodities, property and collectibles) going back to 1926. It found that the latter are cheaper, relative to the former, than at any time in this 90-year period. The adoption of quantitative easing (QE) by central banks has had a much greater impact on the price of financial assets than on property.
So some of the recent market trends may simply stem from a feeling that real assets have become too cheap (or financial assets too expensive). Perhaps this may turn out to be a significant change in trend, but even then the really tricky bit will be deciding whether there is more money to be made from buying property and gold, or from selling equities.
It would be surprising, however, if real assets rose as far (or financial assets suffered as much) as they did in past cycles. First, the commodity bull market of the 2000s was largely driven by China’s investment boom, and it is hard to see that being repeated. Second, as the developed world ages, baby-boomers will be trying to offload their properties to struggling millennials—hardly the recipe for an extended property boom.
Meanwhile, central banks have repeatedly shown that they will fire the monetary bazooka if financial markets take fright; they would welcome neither a collapse in equity markets nor a big leap in bond yields.
In short, there may well have been a short-term turnaround in financial markets because deflationary fears went too far, and bond yields fell too low. But a lot more evidence is needed to declare this a long-term turning-point of the kind seen back in 1982.