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Does the sell-off signal the start of a bear market?

FOMO, or the fear of missing out, was the overriding concern..

FOMO, or the fear of missing out, was the overriding concern for stock market investors as we entered 2018.

But markets can quickly change tack, and the first few days of February have seen investors dump equities over fears that the bull run is coming to an end.

This sell-off has been prompted by mounting pressure in the bond market, as the benchmark US 10-year Treasury bond hit 2.9 per cent last week, its highest point in four years. The bond market has been under the radar for a while, but investors are finally starting to notice that yields are rising.

Read more: FTSE 100 follows global stock market sell-off as bond yields jump

There are several schools of thought about what has caused this rise. On one hand, it’s thought that markets could be pricing in stronger growth and inflation, particularly as tax reforms in the US trigger another growth-spurt. This could potentially force the Federal Reserve to raise rates quicker than expected.

But it’s also thought that the US bond market is finally adjusting in line with Fed expectations, which is forecast to raise rates three times this year.

The heat has now reached a level where the first signs of discomfort are becoming clear, says AJ Bell’s Russ Mould. This discomfort is being felt in the equity market, and Friday was Wall Street’s worst trading day in more than two years.

Rising bond yields can make equity returns look less attractive, therefore causing money to be sucked out of the stock market.

Pundits suggest equity investors shouldn’t fret too much because the Fed will continue to tread carefully to avoid upsetting the fragile recovery. But if the bond market rise is a result of a recovering economic picture, this can be a positive for share prices too – since they suggest economic and corporate earnings growth, says Mould.

He also points out that the equity yield on the FTSE All-Share index currently beats the yield on the benchmark UK 10-year gilt.

“This suggests that there is still little real need to be wary of a bond-to-equity switch in the UK providing economic and earnings growth do not disappoint.”

Most major stockmarkets have had an incredible run over the past year, hitting record levels just last month. But as valuations have hit eye-watering highs (sometimes for some pretty mediocre companies), it’s clear that markets are long overdue a correction. The question now is whether this is the reversal of the stock market euphoria.

“The game can’t play forever; you’ve seen chief executives being rewarded for share price movements, even though some of those rewards probably weren’t justified,” says David Coombs, head of multi-asset investments at Rathbones.

Coombs reckons the market is reverting to fundamentals, adding: “we’ve seen what’s happened to Capita and Carillion, with investors marking companies down that don’t provide growth and disappoint through profit warnings.”

Read more: Capita shares jump as fund manager claims it "flouted basic rules"

We’ve also seen a surge of passive investing over the past 10 years, which the multi-asset boss says has created a “wall of liquidity” that has pushed valuations up.

For fixed-income investors, this certainly seems to mark a change in tone. Bond yields have been below the rate of inflation for a long time now, and fixed income investors haven’t been paid for the risk they’re taking in credit markets. But investors are waking up to this shift, and some speculators have started reentering the market.

Adrian Lowcock, investment director Architas, says bond markets have some catching up to do. “The market is becoming increasingly concerned with the possibility that the Fed will have to raise rates even faster than they have indicated. “the weak US dollar could lead to higher inflation, while the tax reforms agreed at the end of last year, could result in stronger growth than has been forecast.”

It’s clear that markets are finally taking the prospect of tighter monetary policy into consideration.

However, the 10-year gilt yield is currently lower than inflation, so bond yields are not a long-term threat to the stock market bull run just yet. As it stands, investors shouldn’t be too worried.

Maybe we’re heading towards a period of normalisation – that is, a correction, rather than the start of a bear market.

Fidelity International's multi-asset chief, James Bateman, even goes as far as to say this is the greatest sign of real health in markets for a long time. "The tech-fuelled rally in the US had long lost any sense of reality in its valuations, the prospect of inflation remaining low forever could not last, and we have a new and untested Fed chair. It would be more worrying if markets didn’t react to all of this."

But if the economy disappoints and it turns out that central banks have already tightened too much (at least in America) then Mould warns “there could still be trouble ahead”.

Ultimately, this serves as a reminder that investments can fall as well as rise. Now is the time to make sure your investments are in a fit state to withstand any turmoil.

Original Article