US inflation concerns drive volatility

Recent positive data on US jobs and wages has shifted investors’ thinking around inflation and the potential for a faster increase in the US Federal Reserve interest rate than previously expected.

The job market in the US continues to improve with the unemployment rate at 4.1% - the lowest level since 2001. US Average hourly earnings grew 2.9% in the year to January, which was surprisingly strong and the highest level of growth since 2009. This level of wage growth combined with a tightening labour market is affecting investor’s inflation expectations. This has led some commentators and market participants to start thinking that the US Fed may have to raise rates four times in 2018 instead of three times, which was previously the consensus expectation.

Higher interest rates expectations resulted in markets being sold down
Expectations of higher interest rates than previously anticipated from a share market perspective has the effect of decreasing investors’ valuations on stocks. This has given rise to a sharp fall in US stock prices, with the S&P 500 index down over 10% from its high on 26 January.

Interestingly, bond markets have also experienced losses with the market adjusting yields right along the curve as bond investors also anticipate higher interest rates in the future. This movement has resulted in significantly higher daily swings than has been seen for some time. The increase in volatility is, at this point, a reflection of an adjustment in the markets. How long it could persist is difficult to determine. However, the economic fundamentals remain sound but valuations remain somewhat stretched. So, in light of the adjustment to US interest rate expectations, depending on what investors focus on, determines the extent to which the share markets will continue to be volatile.

What about fixed interest markets?
With higher interest rates expected it makes sense that bond markets have seen yields rise across the curve. However, unless expectations continue to change significantly, the volatility in the fixed interest markets could be expected to settle down relatively quickly. Consensus among fixed interest managers is that it will be difficult for US 10-year yields to hold above 3.0% in the longer term. The level of indebtedness makes higher rates a problem for the US government with its expanding deficit. While the economy is improving, significant interest rate tightening could be damaging to the economy. In Europe, higher rates can be expected but there has not been any significant changes in relation to the drivers of this so it’s unlikely the current volatility in markets will be significantly affected by Europe or any other markets.

Stick to the plan
An investment portfolio that is well diversified and built with long-term objectives in mind means that while these times are worrying for investors they are not something we should react to. With the strong returns experienced recently, a little weakness in markets is not unhealthy and quite possibly a little overdue.
Speak to your financial adviser to find out more about your investment options.

Source: IOOF

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