Reflation and Reflection


  • Reflation and Reflection
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In all the places I have traveled in the past year (and there are a lot of them), investor sentiment has been similar. Gratitude at the amazing returns has been tinged by nervousness over the height of asset values and the dearth of volatility. Termed by The Economist as the “Bull Market in Everything,” the cycle seemed ripe for a correction. Some actually expressed a hope for one, to prompt additional perspective.

It is said we should be careful what we wish for, because we just might get it. Beginning late last week, stocks finally stepped back. Market declines of 5% and even 10% occur with some regularity, even in the midst of long bull intervals. But because it has been such a long time since one had happened, the associated nervousness was amplified. Some in the media even went so far as to suggest that something systemic was in the works.

My colleague Jim McDonald covers the market angle well in his piece “The Return of Volatility.” In this column, I will examine the root causes of the market’s collective concern and assess whether the alarm is justified.

Asset prices have benefitted importantly over the past few years from low interest rates. Nearly a decade after the financial crisis, monetary policy in developed markets remains extraordinarily accommodative. Overnight interest rates are still low and central banks continue to carry large balance sheets. As a result, long-term interest rates across countries have been well below historical norms.

Additionally, tight credit spreads, easing lending terms and low levels of market volatility have combined to create easy financial conditions. Prior to the recent correction, indexes measuring financial conditions had exceeded their 2007 highs.

Last fall, the strength of the global economy prompted bond market participants to reevaluate. Ten-year yields in the U.S. are 80 basis points higher since last September, and sovereign yields in other markets have also moved upward. That led to worry that one of the foundations of asset price increases was cracking.

It bears mentioning, though, that interest rates remain low by historical standards. And if interest rates are rising because global economic strength is generating demand for capital, that combination of circumstances should be supportive for markets.

Nonetheless, the anxiety over rising interest rates was in the background when the U.S. employment report came out last Friday. Within the release was the highest reading on wage growth in nine years. This single number appears to be the leading suspect in the search for the root cause of the correction.

Faster wage growth is not at all unexpected. U.S. unemployment is just above 4%, and unemployment in other parts of the world has been declining. Reports of wage pressures have been mounting, and business surveys reveal an expectation that retaining talent will require paying up. Forecasters and central bankers have factored this into their estimations of future inflation.

But it seems unlikely that wages will escalate uncontrollably. There remain powerful secular governors: the advance of automation, global sourcing and corporate discipline. Further, productivity growth remains disappointing; wages are closely tied to potential output.

Even if wages rise more rapidly, the historical link between wages and inflation is weak. During the past two expansions, wage growth reached a 4% annual pace without creating much (if any) pressure on the overall price level.