The recent correction on the equity markets should be seen in relative terms. The downturn comes at a time when the economic context is still buoyant, after an almost uninterrupted climb since the beginning of 2016. In an article on "Market News" in the 16 February 2018 edition of Luxemburger Wort, Damien Petit, Head of Portfolio Management at Banque de Luxembourg, offers some explanations.

The rise in bond yields was the main trigger for the recent correction on the equity markets. By way of illustration, the US 10-year Treasury yield has gained around 40 basis points since the start of the year, taking it close to 3%. At the beginning of July 2016, the yield was still below 1.4%!

Fears of the US economy overheating are at the root of this upturn in yields. After nine consecutive years of expansion, the very accommodative fiscal policy is inevitably giving rise to fears of inflation. Despite an already very advanced American economic cycle, the recently approved tax reform and President Trump’s intention to finance significant infrastructure spending are likely to further stimulate the economy, crucially ramping up the budget deficit and generating potential price tensions.

As a result, investors were spooked by the announcement of 2.9% year-on-year growth in the hourly wage in America in January, the highest increase since 2009. Inflation expectations reflected on the US bond market are also rising:  the annual average consumer price rise expected for the next ten years is now slightly over 2% in the US, compared to less than 1.7% in mid-June 2017.

The correction on the equity markets was amplified by technical factors. Many funds following “risk parity” type strategies, where the level of exposure changes according to volatility, were forced to drastically pare back their positions. The abrupt bout of volatility also led to the collapse of several products designed to provide inverse exposure to futures contracts on VIX volatility, generating additional fears over the exposure of certain banks to these products. The important role of these technical factors is further illustrated by the slim repercussions of the equity market correction on the spreads of bonds issued by low quality debtors (“high yield”) or on the price of gold, the ultimate safe haven.

This equity market correction can be considered healthy as it came after a very long period of growth on the markets in a context of extremely low volatility. Even very recently, various sentiment surveys conducted among private and institutional investors showed a high level of optimism, reflecting a probably-over-high degree of complacency in a number of market participants.

Is there a danger of a much bigger fall? 

The economic outlook has not been severely tarnished following the fall on the equity markets. Surveys conducted among purchasing managers (PMI) have held up at levels commensurate with solid global economic momentum. Despite signs of a slight increase in wage hikes, inflation is currently contained globally. Meanwhile, valuation levels on the equity markets have dipped a little.  In relative terms, the outlook for yield continues to look considerably more favourable for equities than bonds, despite the compression of the risk premium.

So investors exposed to equity markets should, on the one hand, get used to more sustained volatility given the maturity of the business cycle and, on the other hand, expect yields below the historic average.