By Oliver Mangan
Many commentators had been warning recently that stock markets looked to be heading for more turbulent times given stretched valuations, a prolonged period of uninterrupted gains, very low volatility and signs of a return of “irrational exuberance” in certain instances.
This was all occurring in the context of central banks starting to wind back extremely accommodative monetary policies, putting upward pressure on bond yields.
It is worth noting that the adverse scenario for the 2018 EU-wide banking sector stress tests is not based around economic factors or the fall-out from Brexit, but rather “an abrupt and sizeable re-pricing of risk premia in global financial markets” that results in a large fall in asset prices.
Meanwhile, although both the IMF and OECD recently upgraded their growth forecasts for the world economy, they also warned that elevated valuations in the major global equity and bond markets left them vulnerable to a sizeable correction.
In the end, it was a pick-up in wage growth in the US that triggered sharp falls in stock prices this month and the return of volatility in markets. But even if it was not wage data, we believe that something else would have unnerved stock markets as they were ripe for a sharp correction.
What we are seeing is a return to more normal trading conditions in markets.
Bond yields look to be on an upward trajectory, which is a challenge for equity markets. But higher yields are being driven by favourable economic developments, not concerns about asset quality and credit risk, which is a long-term positive for financial markets.
Hence, we do not see major spill-over effects into the real economy from the setback in financial markets. Interest rates may be rising, but only modestly and off a very low base.
Neither, do we see this as the start of a major crash. As long as global inflation stays subdued, central banks can be patient about withdrawing monetary accommodation and, thus, raise rates at a slow pace. This should help avoid a major upheaval in markets.
Overall though, it would appear the easy ride for investors is now over. Bond yields are likely to rise further. Stock markets will likely need continued good corporate earnings reports to start moving higher again.
Volatility is back in a return to more normal market trading conditions.
Oliver Mangan is chief economist at AIB.