THE MARKETS STILL HAVE PLENTY TO FRET ABOUT / THE ECONOMIST

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The markets still have plenty to fret about

With share valuations so high, volatility, junk bonds, growth and China are all cause for concern


BULL markets always climb a wall of worry, or so the saying goes. For much of 2017, the main concerns were political and the markets seemed to surmount them as easily as a robot dog opens doors (the latest internet sensation).

But February has shown that the market is still vulnerable. The immediate trigger seems to have been the fear that inflationary pressures would cause bond yields to rise and central banks to push up interest rates; this week’s surprisingly high American inflation numbers will only add to the worries. In a narrow sense, that makes bonds look cheaper, compared with equities. In a broader sense, it increases the discount rate investors apply to future profits, lowering the present value of shares. (A caveat is needed: if higher rates reflect stronger growth, then estimates of future profits should rise, offsetting the discount-rate effect.)

The immediate effect has been to create uncertainty for investors about the direction of central-bank policy, after many years in which it could reliably be assumed that rates would stay low.

This translates into a more volatile market, as illustrated by the sharp jump in the Vix, or volatility index, in early February.

The danger is that many investors seem to have treated volatility as an asset class, and have organised their portfolios accordingly. Eric Lonergan of M&G, a fund-management group, warned in a blog that “endogenous instability is rising, and volatility is at the core. Volatility has virus-like properties. It started as the domain of a small specialist group of quants. And it has spread to infect everyone.” Too many people use volatility as a measure of risk, but the real risk is the permanent loss of capital, he points out. A focus on short-term volatility may lead to herd behaviour on the part of investors, creating the risk of a sudden sell-off.

Another area which could be subject to stress is the corporate-bond market. According to Moody’s, the yield on American speculative (or junk) bonds reached 6.44% on February 9th, the highest since December 2016. The value of the largest junk-bond exchange-traded fund fell sharply (see chart). If the world economy keeps strengthening, companies should be able to meet their interest payments. Moody’s thinks the default rate on junk bonds will fall from 3.2% to 2% by the start of next year.

But the market has changed since the crisis of 2007-08. A decline in bank lending has forced European companies to turn to the bond markets; high-yield bond-issuance in the years 2013-17 was three times higher than in 2008-12, says Ironshield Capital, a fund-management firm. Banks are also devoting less capital to market-making, meaning bonds could be hard to sell quickly. “Corporate credit could be the next crisis in the making,” warns Absolute Strategy Research, a consultancy, raising concerns about “potential liquidity issues associated with high yield”.

A third possibility is that markets may be too optimistic about economic growth. China’s purchasing-managers’ index for manufacturing has slipped back in recent months, and its credit growth has fallen to its slowest rate in 31 months. John-Paul Smith of Ecstrat, a consultancy, worries that the risks for the Chinese economy will be compounded by worsening tensions with America, and that these are likely “to become much more visible over the coming weeks, across a broad range of policy areas in addition to trade.” Both the Bloomberg Commodity index and the Baltic Dry (shipping) index, indicators that are sensitive to global demand, have dropped back in recent weeks.

Of course, over-optimism about growth would mean that central banks have to be less vigilant about inflation and bond yields might come back down. But this would not be great news for equities, especially as analysts are forecasting nearly 18% profits growth this year for companies in the S&P 500, according to Andrew Lapthorne of Société Générale, a French bank. That leaves plenty of scope for disappointment.

A related problem is that the American market represents more than half the MSCI World index, which means that people who think they have a diversified portfolio actually have a concentrated bet. As Mark Tinker of Axa Investment Managers points out, the last time one country comprised so much of the global index was Japan in the late 1980s. That did not work out so well.

Some or indeed all of these worries may never be realised. But with the cyclically adjusted price-earnings ratio on the American stockmarket around twice its long-term average, equities are vulnerable to any kind of bad news.