The Dow Jones index fell by 666 points on Friday. Woooh!
It sounds less spooky when you point out that it’s a drop of 2.5%. That’s pretty piddling in the grand scheme of things. But piddling though it may be, the market did go down, and that’s not something we’re used to these days.
Meanwhile, bitcoin and its crypto-chums got slaughtered and bond yields headed higher (which means bond prices fell).
Oh, and even the old standbys, the precious metals, didn’t look too perky.
Is this the beginning of something much bigger?
Wage inflation is starting to pick up
On Friday, the US S&P 500 fell by 2.1%. Believe it or not, it hasn’t done that since September 2016. That makes it the biggest loss of the Donald Trump era.
That’s a very good run. And it’s possibly one reason why everyone seems to be taking the drop on Friday so personally.
So what’s spooked the market? In a word, bonds.
The equity market has finally woken up to the fact that something has changed in the world.
On Friday, the US non-farm payrolls data came out. This is the most important employment statistic in the US (and as a result, the world – at least in terms of market impact).
The non-farm payrolls data measures how many jobs were added to the US economy in the past month. It’s called “non-farm” because it excludes agricultural jobs, but they are now such a small proportion of the total that it doesn’t matter.
So 200,000 jobs were added, which was a bit above market estimates. However, it was another figure that put the cat among the pigeons. Average hourly earnings rose by 2.9% year on year. That was well above the 2.6% forecast.
Wage inflation has been the missing link in the economic recovery story. If that comes back then it means inflation is rising, and the Federal Reserve will be put under pressure to keep raising interest rates.
Given all the talk of the bond bear market, the US ten-year Treasury needed no further excuse to fall. The yield on the benchmark US government bond rose above 2.8% (yields rise as prices fall) and is now clearly itching to break through 3%, which is yet another major “line in the sand” drawn by chartists and other technical analysts.
The trouble with rising bond yields
What does this all mean? As we’ve discussed before, whatever the cause – and a stronger global economy is a good thing – rising bond yields are “problematic” (to use the term du jour) for financial markets for a number of reasons.
For a long time, we made the point here that while loose monetary policy hadn’t done much for the “real” world, it had done an awful lot for the financial world. That’s now starting to turn. The “real” world is perking up, but that suggests that harder times lie ahead for finance.
We have grown used to money becoming ever-cheaper. If bond yields continue to rise, then that cosy world will be gone.
Here’s a very simple summary of the problem.
If your savings account pays you 0% interest, how much does a portfolio of blue-chip stocks need to offer you to persuade you to take the risk of owning them? What about a portfolio of government bonds? And how about a rental property – what yield would you accept?
Got your rough answers in mind? (There’s no right answer, just what you think.)
OK. Now say that your savings account pays you 5% interest. Does the yield on all of these other assets now need to be higher, or lower, to tempt you?
There is a right answer in this case, and it is, of course, higher. Maybe quite a lot higher. And the thing is, if your need yields to be higher, then the quickest way for that to happen is for prices to go down.
Of course, there is another way.
Say you have a property that’s worth £100,000. You own it outright. You’re happy to accept a 5% yield, so you’re getting £5,000 a year rent from it. To get a 10% yield, either the price falls to £50,000; the rent doubles to £10,000; or you see a bit of both happening.
The least disruptive outcome for the asset owner is if the asset price remains static and the rent doubles. But the only way for that to happen is if inflation rises to levels that we haven’t seen for years.
Yet I suspect that this is the end goal for our monetary authorities. Falling asset prices punch holes in banks’ balance sheets and send people into panic. Far better (at least, they think for now) to see inflation rise rapidly and asset prices to decline in “real” terms but not in nominal ones.
As the FT reports, the Fed is already starting to put its stabilisers in place. John Williams of the San Francisco Fed said on Friday that, “while the outlook is positive, it’s not so strong that it’s driving a sea change in my position. For the moment, I don’t see signs of an economy going into overdrive or a bubble about to burst.”
I’d expect the world’s central banks to find all the excuses they can to tolerate higher inflation.
Meanwhile, chances are that bond yields will rise too far and too fast, and then will be reeled back in. Stockmarkets in turn will view the spasm of panic as a “buying opportunity”. And there have been several such buying opportunities in the recent past – the China panic of late 2015 was one obvious one.
But this is the point at which I’d be looking at the gains you’ve made in recent years and figuring out how to lock them in and take some risk off the table. If it’s finally time for “Main Street” to profit at the expense of “Wall Street”, then it’s hard to see how any financial asset comes through that unscathed.