Things just got a little more interesting on the global capital markets stage, volatility has picked up markedly in equity, bond and currency markets from the start of the year. Bond and equity volatility has jumped about 20%, using the Vix and the MOVE index. Currency markets also but to something of a lesser degree. Is 2018 beginning to have certain similarities with 1987 about it? There are a few similarities, but also some distinct differences. Bond markets, as we know, have been in an extended bull run for over 30 years because of central banks targeting inflation. As in 1987 yields are starting to creep higher, however, the starting point was already far higher than they are today.
For those who remember the sharp correction in 1987, it was not caused by a change in sentiment towards global economic growth, in fact, the sentiment was rather positive as it is today. Also like today, rising interest rates were in response to what was an improving global economy. Ronald Reagan, rather as Trump has done, looked to stimulate the US economy with large across the board tax cuts. In 1986 he cut the marginal tax rate for high earners from 50% to 28%. The stock markets rallied rather as they have done so in the previous 6 months this time around, with monotonous regularity and volatility remained low. Towards the second half of the 1980’s bond yields started to rise, anticipating higher inflation from the fiscal stimulus. However, all equity investors focused on was the prospect of improving economic growth, driving equity prices ever higher.
Interest rates are important to equity valuations, the price of an equity is based upon the added return you expect over the risk-free rate for the extra risk from owning an equity. If you can receive a better return in the bond market, equities require a lower rating to encourage you into the asset class.
So far, the selloff in bonds has been even paced, and yields still do not look that attractive relative to history. Equity valuations outside of the US are not extreme and close to historic norms. The correction in 1987 was dramatic as was the selloff in bonds, but one must remember that today 10-year US treasury yields are still circa 2.7%, in 1986 they went from 7.5% to 10% in 1987. Quite a different proposition.
Having just attended the Moody’s investor conference, like so many analysts currently they see pretty much sunshine and little in the way of economic clouds looming on the horizon. If we did get another 1987 style correction, considering the current climate, it is likely to be a far more muted affair. The good news is that 1987, painful though it was, led to a sustained period of economic growth and offered those who were quick and agile enough a great opportunity to own the equity market. Just remember that if we see a repeat, even on a modest scale.