Stocks bounce, but there’s trouble ahead

After the nasty slip-up earlier this month, equities bounced back strongly last week. Yet the source of all the fuss – the rise in US bond yields and signs of inflation returning – hasn’t gone away.

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We've had our appetiser how much longer before the main course arrives?

Was that it? After the nasty slip-up earlier this month, equities bounced back strongly last week. The FTSE 100 had its best week in two years, gaining almost 3%, and the US's S&P 500 index bounced by 4.3%, its best outing in five years. Yet the development that caused all of the fuss the rise in US bond yields amid signs of inflation returning hasn't gone away, as Richard Barley points out in The Wall Street Journal. Indeed, the US ten-year Treasury yield, which is the benchmark for world debt markets, has edged up to a four-year high above 2.9%.

What's more, adds Randall Forsyth in Barron's, last week's data showed that in January inflation as measured by the consumer price index (CPI) jumped by 0.5% and is now running at an annual rate of 2.1%. Price rises have speeded up lately too. Over the last three months, CPI has reached 4.4% year-on-year.

Interest rates are still low

It always takes time for markets to get used to important new trends (equities kept climbing long after the first signs of the credit crisis had emerged in the mid-2000s, for example), and it seems to be a similar story this time. Investors appear to be comforting themselves with the thought that it is still very early days in the shift towards higher interest rates. Indeed, inflation-adjusted US short-term rates are still negative, as Morgan Stanley points out.

Moreover, in other major economies, the cost of money is still nailed to the floor and central banks continue to create electronic cash. That means there is "a huge amount of liquidity still looking for a home", says Rebecca O'Keeffe of Interactive Investor. So central banks will provide a tailwind for equities for now. A strong global economy, and high US earnings growth, are also bolstering confidence in stocks.

Headwinds gather strength

But as rates rise the cost of borrowing for companies will climb, and the relative appeal of fixed-income investments will rise. Expectations for US earnings growth are very high: analysts are pencilling in an 18% increase for S&P 500 firms in 2018, so there is "plenty of scope for disappointment" in the already overpriced US stockmarket, as The Economist's Buttonwood columnist puts it. Higher wage and borrowing costs will nibble away at corporate margins.

If inflation does get going, it bodes ill for stocks, says Fidelity's Tom Stevenson in The Daily Telegraph. Since the 1930s, US stocks have delivered real total returns of 14% per year in periods of falling inflation, but "pretty much zero when it has been rising". Given all of this, it's hard to disagree with Morgan Stanley's view that January's wobble was an "appetiser" and the "main course" is still to come.

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