Stock markets: more volatility may lie ahead

The sharp sell-off in equity markets in recent days will have come as an unwelcome shock to investors. Stock markets made strong gains last year and volatility was notably absent. Now the debate is whether this is a temporary correction, after investors were lulled into a false sense of security, or something more fundamental. Markets analysts differ, suggesting that more volatility may lie ahead.

Equity markets had an extraordinary run last year and the US market, before the latest falls, was some 40 per cent ahead of where it was when President Trump was elected. Perhaps just as remarkable was the calm nature of trading, particularly over the last year or so. On any measure shares are now generally strongly valued in relation to expected future profitability. This left the market vulnerable.

The immediate trigger for the fall was US wage figures published last Friday, showing an annual growth rate of a strong 2.9 per cent. This increased concern among investors about the return of inflationary pressures and the impact on interest rates. These fears are already being reflected in government bond markets, where long-term interest rates are on the rise.

The wage figures led to falls in US markets on Friday, which continued into an extraordinary trading session on Monday. The extent of the swings in trading appeared to relate in part to computer generated trading programmes and also to certain investment funds getting caught out, having effectively made bets that the market would remain calm. There may be issues here for regulators to look at. But in the short term investors will wonder what happens next.

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The unprecedented nature of the central bank actions during the crash, and the uncertainties caused by their gradual withdrawal, will be the dominant theme on financial markets in the months ahead

No one seems quite sure. On one view the US market was due a correction after a strong run, but will be supported by strong economic growth and corporate profitability, albeit that shares are unlikely to record similar gains as in 2017.

The contrary view is that the market has been inflated into a bubble due to the low interest rates and massive injections of cash into the economy engineered by central banks to combat the economic crash. As this stimulus is gradually withdrawn, more pessimistic forecasters believe that the markets are vulnerable, with the cost of borrowing rising for companies, many of whom are highly leveraged. Also, higher interest rates provide a risk-free home for investment cash and make it more difficult to attract money into equities and other risky assets and investments.

More volatility may lie ahead as the markets test which of these theories is correct. The unprecedented nature of the central bank actions during the crash, and the uncertainties caused by their gradual withdrawal, will be the dominant theme on financial markets in the months ahead, both in the US and Europe. Whatever happens in the next day or two, this one still has a way to run.