JASON HOLLANDS

Since the global financial crisis, financial markets have frequently exhibited truly odd and counterintuitive behaviour with bad news in the real world often greeted as good news by the capital markets and vice versa. That’s because the key driver for financial markets over this period has been the abundant supply of a wall of cheap money by central banks such as the US Federal Reserve, Bank of Japan, European Central Bank and Bank of England through a combination of ultra-low interest rates and the creation of new money to then be used to buy bonds in order to prop up prices and in doing so keep borrowing costs artificially low. This vast experiment in financial alchemy has hammered cash savers but turbo-charged investment returns by enabling businesses to borrow cheaply (often to then to buy back their own shares) and it has encouraged investors to pour into stock markets in the search for the levels of income that can no longer be found from cash traditionally safer havens such as cash and bonds.

While these emergency measures were only ever intended to act as temporary painkillers to support the financial system as it healed from the crisis, markets have got rather addicted to these measures and therefore any signs that the medicine is about to be reduced have had tantrum provoking potential.

While 2017 saw financial markets exhibit the calmness of a duck pond while surging ever higher, so far in 2018 they provided investors with a white knuckle rollercoaster ride. While January saw stock markets surge to new highs, the bond markets erupted with volatility as the prospect of interest rate rises across the globe and the withdrawal of stimulus programmes has sunken in.

The last week has seen contagion spread from the bonds into the stock markets, with the VIX Index which measures stock market volatility, posting its biggest daily climb ever on Tuesday. In a dramatic few days, steep losses across ricocheted across the globe only to be followed by the biggest one day rebound by the US market in in five years by the middle of the week.

Ironically, all of this drama in the dystopian world of financial markets was triggered by good news from the real economy in the form of much better than expected US jobs data. That spooked the markets because it raised the spectre that a tighter labour market in the US from a buoyant economy could see US inflation accelerate and in turn prompt the US Federal Reserve to raise interest rates more aggressively than the markets had anticipated. In this respect, President Trump’s massive tax cuts, providing a fiscal boost to an economy that is already in good shape, could be ill-timed.

In other words, in recent days investors have woken up to the possibility that the punch bowl of cheap money could be yanked away earlier than expected. This prospect has shattered complacency after a prolonged period of low volatility and when valuations have been looking stretched.

Many investors will of course be unnerved by the dramatic moves on markets seen in recent days. But in times like these, long-term investors should endeavour to hold their nerves and avoid the temptation to rush to the exit door and panic sell. In truth, a correction in markets has been long overdue and this release of pressure is a healthy antidote for over exuberance. Over time this may be seen as an important rite of passage as the financial system returns to normality.

This week’s tantrum in the markets should be taken as a warning shot to investors not to take risk for granted and that further volatility can be expected as the props of central bank stimulus are slowly pulled away. This does not mean a bear market is lurking around the corner, as the underlying outlook for global economy is in rude health with strong earnings growth seen this reporting season. But it is certainly a time to be much more mindful of risks than has been the case in recent years and a lot morning discerning in the choice of investments and companies held rather than just being “in the market” per se. It is a time to ensure investment portfolios are well diversified, invested in funds with defensive characteristics and which not overly exposed to those parts of the markets where valuations have become excessive compared to longer term trend.

Jason Hollands is Managing Director at Tilney Investment Management