What are the markets really afraid of?

The recent surge in stock market volatility has been blamed on fear of inflation, says Brian Durrant in the Fleet Street Letter. But markets aren't actually behaving as if inflation is a threat. In fact, investors appear to be more afraid of an economic slowdown, brought on by the Federal Reserve raising interest rates too far. And he believes that could present a buying opportunity...

After the shake-out starting last month, the investment community is deeply divided. In one camp sit those who believe the markets have much further to fall. Buying shares amid the current turbulence is as dangerous as trying to catch a falling knife, they think.

On the other hand, the bulls say equity looks a glaring buy. Consider valuation yardsticks such as the price / earnings ratio. The FTSE 100 index is on a historic multiple of 13 times earnings hardly demanding, and lower than the P/E ratio at the bottom in March 2003.

So which camp is right? Well, it might help us to examine the cause of the market's setback in the first place...

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Stock market volatility: inflation vs. economic slowdown

The proximate cause of the slide in share prices last month was an 'inflation scare' in the US. But if you look at the reactions of different assets and different sectors of the stock market, it becomes doubtful that the fear of inflation was the root cause.

If the markets were primarily worried about inflation, you would have expected to see the price of gold bullion rallying and government bond prices in retreat. But the opposite happened!

Meanwhile, you would have expected sectors which thrive in an inflationary environment to outperform. But commodity-linked sectors like mining, industrial metals, oils and forestry came off worst. Indeed, the reaction of global markets in the last month is best viewed not as fear of rising inflation, but fear of an economic slowdown.

How can worse-than-expected US inflation data get the markets worrying about slowing GDP growth? It seems that investors are concerned about the new Fed Chairman Ben Bernanke. His attempts to be more transparent and data-dependent than his predecessor, Alan Greenspan, have caused more market volatility, rather than less.

Bernanke made an early gaffe when his supposedly off-the-record remarks over dinner to glamorous CNBC TV presenter, Maria Bartiromo, were later broadcast. Since then, he's been struggling for credibility. This week, Bernanke has been trying to present himself as tough on inflation and tough on the causes of inflation, too. The markets have taken this as just another howling mistake.

Last Monday he said that recent increases in US inflation were 'unwelcome developments'. He insisted that the Fed would remain 'vigilant'. These comments provoked a 200-point fall in the Dow Jones index in New York. At the same time, and despite recent weaker US economic data, the chances of a rate rise at the next Fed meeting (28/29 June) have shortened, according to a report in the Financial Times, from 50/50 to about five in six.

Investors clearly reckon that the newcomer at the Fed will want to cement his inflation-fighting credibility. Consequently there is a fear that he will slam down the monetary brakes too hard with interest-rate hikes, precipitating a sharp slowdown in economic activity.

Stock market volatility: interest rate rises

So it is not the threat of higher inflation that is undermining the equity markets, but the fear of monetary overkill. If he were to do this, the bearish case would be validated and the setback seen in May would have further to run.

However, I reckon the markets are jumping the gun. A rate hike at the end of this month is by no means in the bag.

Market traders always have a tendency to look ahead. They get themselves into a lather about forthcoming economic data releases, quickly digest their impact and move on to the next impending economic number. They fret more about when the next interest rate change will come and how large it will be. Traders look less at the lagged impact of interest rate moves already in place.

Too often the markets overlook the fact that it takes many months for past interest rate changes to take their full effect. But the latest figures on growth and inflation are not necessarily the best guide to the next central bank move. In fact, interest rate changes take about twice as long to affect inflation as they do to impact on growth.

The Fed's interest increases over the last 12 months have yet to fully impact on economic growth. Their dampening affect on price pressures is still further away. Mr Bernanke knows this; he's a bright economist, after all. I believe he will not overreact to the current inflation numbers.

Today's situation is by no means unique. Dr Alan Greenspan, the previous Fed Chairman, faced the dilemma of weakening growth prospects and rising headline inflation on three occasions. In 1989-90, then in 1994-95 and again in 1999-2000 the Fed did the same thing. It stopped raising interest rates before inflation reached its peak for the period. As a result, the US economy endured comparatively mild economic downturns as opposed to severe and protracted recessions.

Yet the markets are now pricing in a policy mistake by the new Fed chairman. Whereas for guidance, Mr Bernanke has only to look at his predecessor. Dr Greenspan lasted at the helm from August 1987 to January 2006. He was reappointed time after time because he chose to ignore the 'inflation vigilantes' in the markets and instead delivered strong growth albeit at the expense of repeated asset-price bubbles.

Stock market volatility: is this a buying opportunity?

Remember, Mr Bernanke's reappointment is in the hands of the President, not the capricious and excitable markets. They currently believe there is an 84% chance of another rate hike at the Fed meeting in three weeks time. It follows that if the Fed does indeed tighten policy, equities will be marked down further, but not by a huge amount. If Mr Bernanke takes a leaf out of his predecessor's book, however, and leaves rates unchanged, it could provide the springboard for an equity market recovery.

Look at this the other way round. We think the chances of rates remaining unchanged are greater than 16%. Accordingly, the setback in the markets presents itself as a timely buying opportunity. Look for stocks that are likely to rise strongly if the market is caught short by a pause in Fed tightening, and equities bounce...

By Brian Durrant for the Fleet Street Letter.

Brian has contributed to MoneyWeek with his expertise in investment strategy, for example how to quadruple your dividend income and how to navigate through the stock market in the 2008 financial crisis. He’s also touched on personal finance such as the housing market and the UK economy.