Global markets tumbled as concerns about inflation and higher interest rates drove investors to pull out of equities and bonds.
February brought a sharp reversal in the Putnam Global Risk Appetite Index. It was one of the 10 worst reversals in our Risk Appetite Index in the past 15 years. By contrast, last month we were discussing the strength of the various measures of risk-taking and concerns that some valuations were a little stretched, especially since risky assets rarely do well when interest rates rise.
In early January, the rally in bond yields was more Europe-centric, fueled by meeting minutes from the European Central Bank (ECB) and hawkish comments by several ECB members. However, toward the end of the month that theme waned. The rally in the yields of fixed-income securities continued in February, but with a different flavor. February’s bond rout was more U.S.-focused. Evidence of economic strength, including a tightening labor market and an improving outlook for wage gains, drove bonds yields higher. The market retreat worsened in February on concerns the Federal Reserve will accelerate its rate-hike schedule.
Upside interest-rate risk?
The labor market began 2018 on a strong note as Americans saw wage gains accelerate and hiring improve. Nonfarm payrolls grew by 200,000 in January, and the average hourly earnings gained 2.9 percent from a year earlier, the most since June 2009, according to Labor Department data in February. The jobless rate held at 4.1 percent. The wage growth sparked concerns about rising inflation.
It was one of the 10 worst reversals in risk appetite in the past 15 years.
The data also reinforced the Federal Reserve’s outlook for three interest-rate hikes this year under Federal Reserve Chair Jerome Powell. Powell’s Congressional testimony, on the other hand, raised concerns that a fourth rate increase may be possible. In the aftermath of Powell’s upbeat remarks, stocks plunged by the most since 2016 and the yield on 10-year Treasuries rose. The market selloff continued in Europe and Asia.
Yield curve flattens
As we are already in a hiking cycle and the theme du jour was inflation, the sell-off in rates was led by the front end of the yield curve, and so the curve flattened. Against that backdrop, it is not surprising that European government bonds were one of only two of the asset classes we follow that produced positive returns in February. The other one is non-energy commodities due to the solid performance of agricultural commodities. All other asset classes had negative returns. The outperformers of last month — international equities — were the underperformers this time, partly because the U.S dollar stabilized in February after a sharp sell-off.
As we write this, we essentially have a neutral stance on interest-rate risk globally, but we favor a cautious posture at the front end of the U.S. yield curve, in particular. We believe there is risk that interest rates will move higher. Still, powerful global factors will limit the rise in the 10-year Treasury yield, in our view.
It would be very unusual to have a second consecutive month of such poor risk appetite, but equally it would be unusual to see it bounce back strongly. There are, as always, some cross currents that markets are trying to price; U.S. growth dynamics look to have slipped just a little, but they remain good and the latest commentary from Fed officials has been optimistic. On the other hand, the risks of an economy-disrupting trade war have clearly risen.