Weekly economic briefing: Financial markets – volatility awakens

The Weekly Economic Briefing is written by two senior Deloitte Economists, David Rumbens from Deloitte Access Economics in Australia and Ian Stewart Deloitte’s Chief Economist in the UK. They provide a personal view on topical financial and economic issues. Subscribe to receive the Weekly Economic Briefing in your inbox!

In this week’s blog:

Australian economic briefing
UK economic briefing
International economic briefing

Australian economic briefing by David Rumbens

This section of the briefing provides a snapshot of key economic data and issues of relevance to Australia.

Financial markets – volatility awakens

Last week was a tumultuous one for financial markets. US equities dropped 6–7% in two trading days, and for all the noise since, are nearly back where they were after these initial falls. In Australia the ASX200 is down slightly less than 5% over the same period, very much in the news, but ultimately experiencing a little less pain than in the US.

Many analysts pointed to stronger-than-expected US wages data release on 2 February as the main culprit, raising market concerns that US interest rates will rise more quickly to keep inflation in check.


Chart: Dow Jones and S&P 500 v ASX200 (indexed to 100 at time of Trump’s electoral victory):


It’s useful to put the recent turmoil into some perspective. First, US equities had risen by a whopping 6% just since the end of 2017, leaving them poised for a correction. Indeed, the recent losses only bring US equity prices back to where they were in early December.

Second, market volatility was bound to pick up at some point. We have seen a period of unusually low financial market volatility since Donald Trump’s election victory in November 2016. So if volatility in 2018 remains higher than it was in 2017, this would actually be something of a return to normal.

And there is reason to believe that 2018 will indeed be a more volatile year for markets. The global economy has been on post-GFC life support for a decade now, with the major central banks having slashed interest rates to record lows (and even to negative rates in some cases), and pumping liquidity into the financial system. And all that pump-priming has buoyed asset prices, including equities and bonds.

But major central banks won’t keep their monetary support at extreme levels forever. And as they start to take their feet off their accelerators, markets will inevitably react. Indeed, the US Federal Reserve has already begun this process, raising interest rates five times since late 2015, with more hikes likely this year.

What does this mean for Australia?

A return to more normal levels of market volatility in itself shouldn’t noticeably affect underlying economic performance. Business confidence remains strong across a number of surveys, including Deloitte’s own biannual CFO Sentiment survey.

But the prospect of higher global interest rates does pose a risk. If the local share market falls as a result, Australia’s already unhappy consumers may dial back spending. And Australian businesses could face higher borrowing costs. Whether businesses are borrowing from the banks – which would themselves face higher funding costs – or issuing bonds, their interest rates would go up. That would likely deter business investment. And that’s a problem when a pick-up in business investment is so important to Australia’s growth outlook for the next couple of years.

The silver lining in this scenario, though, would be a likely weaker Aussie dollar, which would boost Australia’s competitiveness and exports.

This moderate slump in consumer and business spending is the biggest risk from faster Fed policy tightening. The lower-likelihood, but higher impact, risk is that markets adjust in a disorderly way – that the events of the past week presage bigger and nastier market falls. That’s not impossible. We’re in uncharted territory here, as central banks edge away from an extended period of what is the most stimulatory monetary policy in history. But if things did get out of hand, central banks would certainly discard their dismissive rhetoric of recent days for decisive action. The global economy can ill afford a surge in interest rates or a crash in confidence – and they know it.

Finally, in the fear generated by markets recently, we shouldn’t lose sight that there’s an underlying good-news story here. Higher wage growth in the US and other advanced economies, including Australia, would be a good thing. Higher inflation as a result of this higher wage growth would also be a good thing. And higher interest rates – if they’re higher because countries’ economies are strong enough to justify them – would be a good thing too.


For more information on the Australian brief, please contact co-authors David Rumbens and Andrew Ponsonby.


UK economic briefing by Ian Stewart

A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. Subscribe to and view previous Monday Briefings at: http://blogs.deloitte.co.uk/mondaybriefing/

Crash, panic, bounce, slide

  • Last week’s equity market gyrations felt pretty dramatic. The US market dropped 5%, the worst week in two years. Europe took its cue from the US, with the FTSE100 and German DAX also down almost 5%. The VIX Index, a measure of equity market volatility, also known as the ‘fear gauge’, shot up from what, until recently, have been very low levels.
  • The trigger for the sell-off was an unexpectedly sharp rise in US wages. This cast doubt on one of the central ideas behind the boom in equities, that inflation, and interest rates, will rise only slowly. For the last ten years the equity market has been able to count on cheap money. Suddenly it looked as if that assumption might be at risk.
  • Interest rate expectations are a key influence on equity values. Low interest rates boost the current value of future expected dividends and are associated with improving economic activity.  Take away low interest rates and equities look less attractive.
  • This did not start ten days ago. Market expectations for interest rates have been creeping higher in the US, and to a lesser extent Europe, since the end of 2016, reflecting an improving global economy. Interest rates, or yields, on government bonds have moved up significantly since August of last year (although not so much in Japan). Over the last year the US Federal Reserve has raised interest rates from 0.25% to 1.5% and has signalled that a further 75bp of rate hikes are on the cards this year.
  • Until last week the equity market shrugged this off. The good news on stronger growth and profits more than eclipsed the upward drift in interest rate expectations, powering US equities to new highs through January. The strength of the latest US wages data came as a wake-up call to the risk of higher interest rates.
  • As equity market sell offs go, last week’s mini panic was small beer compared to the sell-offs that have punctuated America’s nine year equity bull market. The peak to trough decline in the S&P500 index last week was 6%. That compares with a 15% fall in 2010 during the euro debt crisis, a 15% decline following the downgrade to America’s credit rating in 2011 and a 14% fall in 2015-16 on fears of weaker global growth.
  • Those episodes were deflationary shocks, triggering worry about weak growth and collapsing inflation. Last week’s sell off was the opposite, an inflationary shock, caused by worries that strong growth and inflation would cause the Federal Reserve to tighten monetary policy faster than previously expected.
  • Something similar happened in 2013, in what was dubbed the taper tantrum. Hints from the Fed that it was planning to wind down its purchases of US treasuries through quantitative easing caused a sell-off in bond markets, raising US bond yields and hitting emerging market equities as foreign capital inflows into emerging markets were temporarily reversed. Emollient words from the Fed and a decision to hold back on winding down QE ended that sell-off.
  • Last week’s event are a reminder of what could go wrong. History shows that unexpected rises in inflation and interest rates can rout a long bull market in equities.
  • At least until last week sentiment about the equity market was verging on the euphoric. In the US the latest data show that equity analysts are more bullish about equities than at any time in almost 40 years. The American Association of Individual Investors reports that private investors in the US increased their holdings of equities from 66% to 72% of their assets last year, the highest level since the dotcom boom in 2000. Bank of America Merrill Lynch’s reports that, despite recent gains, most institutional investors do not expect equity markets to peak until 2019 or later.
  • There is no agreed method for judging equity valuations. One I like is Nobel Laureate Robert Shiller’s CAPE ratio, which compares the share prices of US companies to the 10-year average of their real earnings. In the last 120 years there have been only two occasions when, on this measure, equities were more overvalued than they were before last week’s sell-off: on the eve of the Great Crash of 1929 and during the dotcom boom of the late ‘90s. That is not to say that the market is heading down. Stretched equity valuations can get more stretched. As Professor Shiller put it in Davos last month, high though his CAPE measure is at the moment, it is, “not even close to” levels seen at the peak of the dotcom boom.
  • The fact that we are starting from a position of ultra-lose monetary policy is a complicating factor. Interest rates are miles away from what, until 2008, counted as normal levels. To fully unwind quantitative easing, the Fed and the European Central Bank would have to sell over $5 trillion of securities back to private buyers.  Gradual though it is likely to be, it will eventually mean a huge withdrawal of liquidity from the financial markets, just as QE poured vast amounts of liquidity into the system.
  • Bond markets have plenty to worry about. Higher inflation, the unwinding of Q quantitative easing and a surge in US bond issuance to finance tax cuts and higher in public expenditure are bad news for bond investors. Under the Trump Administration public sector austerity seems to be over in the US. Official projections show the US budget deficit rising from $529 billion in 2017 to $955 billion in 2018.
  • The better-than-expected wage growth in the US, combined with tighter labour markets in the UK and Europe, means central banks are having to consider reversing easy monetary policy more quickly.
  • Even in Brexit Britain the outlook is brightening. Last week the Bank of England raised its growth forecasts, and now expects the pace of growth to remain around the 1.8% level seen in 2016 and 2017 through 2018 and 2019. This means faster rate rises than previously expected. Markets now expect the Bank to raise interest rates twice this year and see a greater than 50% chance of the first one coming at the Bank’s next meeting in May.
  • Central banks are alive to the risks of tightening monetary policy too quickly. Their aim is to slowly normalise monetary policy without derailing the recovery or collapsing equity markets. But the world is unpredictable. For all their attempts at reassurance, central banks cannot be sure where the economy or policy is heading. As ever, there is no consensus on where equity markets are heading. But looking at the weekend papers there seems to be general view that financial volatility is hear to stay.
  • William McChesney Martin, Chairman of the Fed in the ’50s and ’60s, remarked that it was the job of central bankers to “take away the punch bowl just when the party gets going”. Last week sell off is a reminder of how quickly the equity market can switch from partying to punch bowl anxiety.PS: German employers struck a landmark deal with the country’s largest workers’ union giving a 4.3% pay rise to 900,000 workers and the right to reduce their working week to 28 hours. The deal, which employers have described as a “burden, which will be hard to bear for many firms”, highlights the power of collective bargaining in tighter labour markets.


The FTSE 100 ended last week down 4.7%, at 7,092 as equities sold off across the globe.


International economic briefing by Ian Stewart

Economics and business

  • The US House of Representatives passed a two-year budget to end a brief government shutdown, significantly raising government spending limits
  • The Bank of England upgraded its UK growth forecasts to 1.8% this year and next
  • UK starting salaries are rising at their fastest pace in more than two and a half years as employers struggle with skills shortages
  • Despite rising consumer debt, UK households are more comfortable with servicing their debt burdens than any time since 2010, according to the ONS
  • UK car sales fell sharply in January, driven largely by a 25% fall in diesel car registrations
  • Labour’s Shadow Chancellor John McDonnell said nationalising water, energy and rail would be “cost free” because government bonds could be swapped for shares in a revenue-producing company
  • A decline in bus and tube passenger numbers in London has been attributed partly to people working from home and using ride-hailing apps, such as Uber
  • The National Institute for Economic and Social Research forecast that the UK’s budget deficit will be eliminated in 2022 due to strong global growth
  • Uber won a legal battle in France with the courts ruling it was not an employer of drivers, in contrast to the ruling in the UK last year
  • Chinese smartphone sales fell last year for the first time since 2009, as consumers wait longer to replace their handsets
  • BIS general manager Agustín Carstens said central banks must clamp down on cryptocurrencies to stop them becoming a “threat to financial stability”
  • Lloyds Bank has banned its credit cards from being used to purchase Bitcoin fearing it could be left in debt if the cryptocurrency plummets in value
  • Eurozone activity, as measured by PMI indices, accelerated at its fastest pace in more than 10 years in January
  • US service sector activity grew at its fastest pace in 12 and a half years in January
  • Jobless claims in the US fell unexpectedly to their lowest level in 45 years boosting expectations for further wage growth
  • Billionaire Carl Icahn said the market will one day “implode” due to wacky funds using too much leverage, but for now it will probably bounce back

Brexit and European politics

  • Angela Merkel’s CDU reached a deal with the SPD on forming a coalition government, further accommodating the SPD’s centre-left, pro-Europe stance
  • A senior German central banker has urged UK banks to speed up their Brexit plans and apply for EU banking licenses to avoid being left “high and dry”
  • The Guardian reported that the EU’s withdrawal agreement will state that Northern Ireland will stay in the single market after Brexit
  • It also reports that UK government papers assessing the economic impact of Brexit shows that the government will need to borrow £120bn more over the next 15 years in the case of a no-deal
  • The number of foreign students applying to British universities has hit an all-time high
  • A UK government “technical note” has called for non-EU countries to agree to treat the UK as if it were still in the EU during any transition period
  • Michel Barnier, the EU’s chief Brexit negotiator, warned that future trade barriers will be “unavoidable” if the UK leaves the EU’s customs union
  • The European Parliament voted against Emmanuel Macron’s plan to create a group of pan-European MEPs after Brexit

And finally…

A cat has been banned from a shop in Bournemouth because of a single anonymous complaint. Dave, the ginger tabby, who was accustomed to siestas by the till and being fussed over by customers, has been banished from the premises after 13 years of unrestricted access – furbidden

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