Until 26 January, everything was plain sailing in global equity markets, and investors went to bed that evening, knowing that the S&P 500 had just closed at another all-time high.
The next day the tide turned – although losses were at first relatively modest. Having said that, in less than two weeks, nearly 10% had suddenly gone out the window.
What had changed so abruptly? Why this sudden pessimism? Why did investors turn negative only a day or two after being prepared to pay record high prices for equities?
The more I read about it, and the more I speak to other investors, the clearer the picture becomes. Yes, the recent sell-off in equities was probably initiated by rising interest rates, although certain abnormalities in the derivatives markets have also taken at least part of the blame for the sudden hiccup.
That said, it is not just a story about modestly rising interest rates; there is far more to it than that. The true culprit was (and still is) a genuine fear of a much more serious bout of inflation than anything we have seen for many years – in other words, a fear that the Fed is now firmly behind the curve.
As you may recall, just before Christmas, president Donald Trump managed to get his landmark tax bill through Congress. The new tax code means a dramatically reduced corporate tax rate for US businesses.
A significant number of US companies have since announced that they wish to share the upside with their employees; ie, meaningful pay rises have been announced but not yet been put into effect.
In other words, if US corporations stand by their early promises, you will almost certainly see a significant increase in inflation towards the end of this calendar year, and the Fed could suddenly look quite foolish.
Only twice in the last 20 years have we seen the Fed turn more hawkish. It happened under Greenspan’s stewardship in 1999 and again when Bernanke started to get cold feet in 2006, and I probably don’t have to remind you what happened to risk assets in both those cases in the months and years that followed.
Am I suggesting we are in for a repeat of the dreadful conditions of the dotcom bust or the global financial crisis? Not quite.
But I am still going to suggest extreme caution in the months to come. We have entered shark-infested waters.
Niels Clemen Jensen is founder & chief investment officer at Absolute Return Partners and a Citywire Wealth Manager columnist