Wage inflation, faster than anticipated tightening and a bond market sell-off are the three potentially interlinked ‘black swan’ events that investors should be aware of over the coming months, according to AJ Bell investment director Russ Mould.
He said there is the potential for several ‘black swan’ events in 2018 – so-called because they are impossible to predict and can have severe implications for markets – given the benign market backdrop of last year.
“Markets are always at their most dangerous when making money seems easiest and healthy returns from global equities in 2017 mean that there is a danger that investors are lulled into a false sense of security, especially as volatility has been remarkably low,” said Mould.
“The FTSE 100 has moved higher or lower by more than 1 per cent in any given trading day just 16 times this year, the lowest number in over 20 years.”
Daily changes in FTSE 100 of more than 1 per cent
Source: Thomson Reuters Datastream
He said: “It is noticeable that volatility rose sharply from the previous low in 2005, reaching a crescendo three years later, and this suggests that investors need to keep up their guard.”
Mould said it could be argued that liquidity and leverage were more plentiful than they were before the financial crisis.
As such, the AJ Bell investment director said investors need to consider what might take liquidity away from the market “and again expose the world to its hefty borrowings”.
He added: “Such events are the sort of ‘black swan’ which could surprise markets and there is a chain of three interlinked events which could stir the markets out of their current complacency.”
Below, Mould considers three ‘black swan’ events that investors should beware of this year.
Wage inflation finally starts to accelerate
The first of Mould’s potential ‘black swan’ events for 2018 is accelerating wage inflation, which has so far failed to keep pace with rising prices despite lower unemployment.
“The market is trying to have it both ways by buying into the global reflation/growth narrative and doing so without pricing in any risk of inflation,” he said.
Unemployment rates have hit near multi-decade lows in the UK, US, Germany and Japan and if tight labour markets lead to higher wages and a wider, faster advance in broad inflation then there could be trouble.
US wage growth vs US corporate profits
Source: FRED – St Louis Federal Reserve database
The first issue, said Mould, is that companies will have to invest in fresh capacity, more staff, higher pay, or all three.
“Corporate profit forecasts do not factor in such a rise in costs, especially in the US, where investors are paying what is a high price by historic standards for what are historically lofty profits and margins – valuations leave little margin for error,” he explained.
The second potential issue in the event of wage hikes and a broader rise in inflation is that central banks may start to tighten policy more quickly than the markets currently think.
Central banks pick up the pace of monetary tightening
Indeed, quicker tightening of monetary policy could lead to the second ‘black swan’ event, said Mould.
With the Bank of England and Federal Reserve both having raised rates in recent months and the European Central Bank beginning to taper its own stimulus programme, central banks have already begun the process of quantitative tightening (QT).
“The pace of change is slow – but if wages pick up and inflation does the same then central banks could be forced to move more quickly, raising rates and tapering quantitative easing,” said Mould.
“In the financial world, higher rates and less quantitative easing (or even QT) mean less liquidity and less cheap cash with which to buy assets.
“Central banks’ reducing their asset holdings rather than increasing them will be a test for bonds and equities alike, especially the latter, which have benefitted from a perceived lack of alternatives when it comes to asset allocation in a low-inflation, low-yield, low-growth world.”
Central bank balance sheet expansion vs FTSE All World index
Source: AJ Bell
Mould said there seems to have been a possible link between the quantitative easing schemes of the major central banks and global stocks, but not yet clear whether that link will hold in the event of QT.
Bond markets – and bond ETFs in particular – take a pasting
And, finally, if both of the above ‘black swan’ events come about, another issue investors might need to consider is the potential for a bond market sell-off, according to Mould.
“Higher wages and costs would expose bullish profit forecasts and equity valuations, which would be further pressured by higher interest rates and QT that would increase borrowing costs and increase the burden of the globe’s huge debts,” he explained.
The AJ Bell investment director said a sell-off in bonds could cause much damage to liquidity, particularly given the popularity of bond funds and bond exchange-traded funds (ETFs) in particular.
“ETFs are useful tools, as they are cheap and can provide diversified access to a range of assets via just the one instrument,” he explained. “They also offer the prospect of liquidity as they are traded on exchanges.
“But the bond market is not liquid. It is an over-the-counter market and one where regulatory pressure is deterring banks from making a market or committing their own capital to facilitate trading.”
He added: “If wages, broader prices and interest rates rise, that is a bad recipe for bonds, where lowly yields could be offset by both inflation and any capital losses suffered – since bond prices fall as interest rates go up.
“That could inflict a lot of pain on bond ETF holders who have either been seeking ‘safe’ yield from sovereign or investment-grade corporate debt or chasing yield from the high-yield or junk market and may find themselves unable to sell easily at the price they want when they would like to.”
Hefty losses in the bond market could “knock a hole in global liquidity flows, dampen investor sentiment and choke off appetite for the corporate debt” which Mould said has been used to fund share buybacks and takeovers that have helped to support stock markets.