Wow! After a confident start to the year, share prices on Wall Street have plunged by 10 per cent and the UK market is down by 4.3 per cent on the week. Yet the economic news looks better. What’s going on?
It’s often assumed “good” economic news boosts financial markets. But this is by no means always so. Certainly the US economy looks to be motoring, with unemployment falling and earnings rising. And over here, forecasts for the year are being nudged up – EY and the National Institute for Economic and Social Research led the way last week. Now the Bank of England has raised its 2018 growth forecast a touch – from 1.7 per cent to 1.8 per cent.
But it also sees average earnings rising from 2.6 per cent in 2017 to 3.1 per cent this year – faster than productivity and likely to put upward pressure on inflation. Bank of England Governor Mark Carney has warned that interest rates would need to rise “earlier” and by a “somewhat greater extent” than thought at the Bank’s last review in November.
Markets have taken this to mean two rate rises are now on the way – a hike in May to 0.75 per cent and a likely second rise in November to 1 per cent.
Why has this all come as a surprise? Wasn’t it expected? Did anyone think ultra-low rates would last forever?
Until last month, there seemed no reason to expect other than gentle rate rises over a long period of time. And given persistent fears since the 2008-09 financial crash that the big threat to the economy was falling prices and deflation, it’s an abrupt change. Many had come to regard low interest rates as a permanent feature – too complacent by half.
But these are still abnormally low by historic standards. So why the market panic?
News of a US surge in pay rates caused bond market investors to price in central bank reaction to inflation concerns – and the likelihood of higher rates – much earlier than expected. This has also coincided with a new governor at the US Federal Reserve, Jerome Powell, who took over from Janet Yellen last week. He may be particularly anxious to assert his anti-inflation credentials from the start. Those with long memories will recall how difficult it was in the 1970s to bear down on inflation once it set in: it was like riding a tiger by the tail and dominated economic policy for a decade.
So what’s the expectation now for inflation? And for interest rates?
Governor Mark Carney fears a combination of rising earnings and record low levels of unemployment, now down to 4.2 per cent, will lead to pressures for pay rises. Already employees who change jobs are seeing pay rises of between 7 and 8 per cent. As workers become more confident about the state of the jobs market, pay pressure will intensify, further pushing the economy towards capacity limits. And this could mean an early end to the present dip in inflation.
To keep any inflation resurgence in check, markets now believe the Bank of England has two interest rate rises in prospect – one taking it up to 0.75 per cent in May and a probably further rise of 0.25 per cent six months later.
Do stock market falls matter that much for the real economy?
Providing it remains a “correction” – a fall in share prices of around 10-12 per cent – there is little by way of direct impact on the “real world”. But a stumble into a fully fledged bear market with sharp and sustained falls in markets would hit both business investment and household confidence. And higher interest rates do have an impact by way of steeper borrowing costs for business and consumers.
Weaker share prices would affect investor appetites for equity paper in mergers and acquisitions. And household confidence would be dented by falls in the value of pensions and long-term savings.
However, bear markets require a causation – typically a sharp downturn in the real economy. There have only been two occasions when there has been a bear market in shares without a recession – 1962 (the Cuban missile crisis) and 1978 (computer programme trading). And at present, with the global economy heading towards growth close to 4 per cent this year, a recession appears unlikely.
How much further are the markets likely to fall?
Shares and bonds may well fall further – until higher interest rate risks are fully priced in and yield attractions are seen to provide compensation for the risk in volatile markets.
And risks extend all the way through unexpected geopolitical events and cyber-attacks to central bank policy error. John Wynn-Evans, head of investment strategy at wealth manager Investec, has likened central bank policy-making to those hotel conveyor-belt toasters: either the toast emerges as a pallid white underdone, or burnt to blazes (he made no reference to a third outcome – your toast pinched by another customer: a metaphor, perhaps, for life in high-tax, high-spend economies).
After sharp movements on the scale of last week, market nerves need time to recover. But often there is a rebound that is as sudden as it is substantial, confirming the reputation of markets for over-reaction.
What should the government do?
Almost certainly nothing, barring a full-scale flight of confidence out of assets. That said, if business and consumer confidence is still bruised by the spring, chancellor Philip Hammond has some spending ammo in reserve if he needs to boost confidence and demand.
Latest figures showed a notable fall in the Public Sector Net Borrowing Requirement in December – it almost halved to £2.6 billion from £5.1bn a year earlier. This took the improvement over the first nine months of fiscal year to £50bn over April-December, down 11.8 per cent on the equivalent period a year earlier.
If the pattern of the first nine months were repeated over the full fiscal year, 2017/18 public borrowing would come in at £40.6bn – substantially below the downwardly revised shortfall of £49.9bn forecast by the Office for Budget Responsibility in November’s Budget.
This should give him some scope to boost spending in the year ahead, without bruising his longer-term debt and deficit reduction targets.
For the moment, however, further volatility can be expected until nerves settle.