During March the U.S.’s S&P500 had its first 1% correction in 109 trading days – the longest such gap in more than 20 years. Last month we observed that global financial markets have been remarkably un-volatile, but quite rightly the higher markets go the more concerned investors become about a pull back. As we wrote last month, there will be mean reversion at some point, but nobody can tell you when, so while the bulls are on the loose you should enjoy the ride. Interestingly, it appears there are a lot of people who have had a really hard time doing that.
The rally in global equities post the GFC has been described as ‘the most hated rally ever’, a reference to the fact that there has been a surprising lack of money go into equities funds, perhaps because of the lingering memory of how awful the GFC was for share investors. The chart below shows that between the start of 2009 to the end of February 2017 the cumulative flow of money into global bonds has been more than double the amount going into equities , yet over that period the MSCI World equities index has risen 120%, while the Barclays Global Aggregate Bond Index has risen only 39%. Double the money getting one-third the return.
Cumulative inflows to equities vs. bonds
Source: Merrill Lynch
It is often said bull markets tend to end in euphoria, when the last marginal dollar has gone in. Based on a simple measure like where people are investing their money, it’s quite possible the bulls aren’t finished yet.
U.S. rate rise
During March the U.S. central bank, known as ‘the Fed’, raised the target interest rate by another 0.25% to a still very low 0.75-1.0%. It was only the third rate rise since the GFC but after the second took 12 months this one took only three. The head of the Fed, Janet Yellen (whom President Trump has earmarked for replacement) tried to reassure markets that they still intend to take things very gradually.
That makes a lot of sense given the main reason for raising interest rates is usually to keep inflation in check, and while inflationary pressures in the U.S. have certainly risen over the past two years, the chart below shows they remain contained. In fact inflation remains very low in Europe and Japan as well.
Core Inflation – Advanced Economies
Source: Thomson Reuters
Central banks tend to focus on what’s called ‘core inflation’, which tries to exclude the effects of more volatile things like energy prices. But in early 2016 commodity prices started a rapid rise, led by oil, coal and iron ore. In fact, the chart below shows the CRB Commodities Index rose some 25% between February and June, but within that time the price of oil, the most economically important global commodity, almost doubled.
CRB Commodities Index
Now it seems the oil price is effectively capped around US$50. At that price U.S. shale oil has taken over from OPEC as the ‘swing producer’, in other words, they are able to bring new production on so quickly and flexibly that it seems the price will find it difficult to get a lot higher, but the OPEC nations can’t afford for it to go much lower.
So oil prices now seem to be trading in a range, and over the next few months those sharp price increases of a year ago will roll out of the inflation data, thus reducing the apparent price pressures again. Unless of course something like wage increases take their place.
Doing the Reserve Bank’s dirty work
Here in Australia the Reserve Bank didn’t raise interest rates in March but the commercial banks did, increasing mortgage rates on average by 0.25% for investment properties and 0.08% for home loans.
There were a few reasons put forward by the banks about the cost of funding going up on global bond markets, which is entirely possible. But with housing prices continuing to run hot in Sydney, Melbourne and Brisbane and the RBA reluctant to raise cash rates for fear of the effect it would have on the broader economy, it’s not beyond the realms of possibility that strong indications were given to the banks that cooling off the property investors would be helpful for all concerned.
These so-called macro-prudential measures may well be used more actively while Australia’s property market remains on a tear but the rest of the economy is limping along, meaning we may see the gap between the RBA’s cash rate and the banks’ mortgage rates continue to widen – see the chart below.