While recent price action feels largely sentiment driven – Citi takes the opportunity to note what we have already shown on several occasions, namely that the correction to stocks accelerated last Friday following the US Non-Farm Payrolls print, and specifically the response to the especially good (and woefully misinterpreted) wage inflation print, which Citi's Global Macro Strategy team believes is "the biggest fear for equity markets."
In addition to last Friday's rapidly rising average hourly earnings print, Citi notes the ISM prices paid number is now at the highest level since 2010, whilst University of Michigan household income expectations one year ahead are surging.
Commenting on these rapidly rising inflationary indicators, Citi's Jeremy Hale notes that "perhaps the equity market is getting worried that we are seeing sustained inflationary pressures."
We have shown previously in our Global Asset Allocation that moving from a ‘Goldilocks’ environment (solid growth, benign inflation) to one of increasing inflation, generally sees volatility increase in equities and Sharpe ratios decrease.
In fact, Citi believes that 1987's Black Monday crash was a consequence of the shift from "goldilocks" to "reflation."
Which means that the biggest risk is also the most obvious one: the negative impact of rising wages on corporate profits:
Furthermore, if we see wage inflation rises, past cycles show great difficulties for firms in passing wage costs to prices in an increasingly open economy. We wonder if equity markets are now becoming concerned about potential margin compression for firms.
They are, and just in case there is still any doubt what is causing the market shock, here is an excerpt from a recent note by Rafiki's Steven Englander, discussing "how it can go wrong for asset markets."
My short answer is that the worst possible outcome is that we hit our inflation targets anytime soon. A quick acceleration of core inflation from 1.3% in the US, 0.2% in Japan and 1.1% in the euro zone to approximately 2% in each country would mean that real interest rates would have to rise to roughly their equilibrium very quickly. It would also mean that the UR was almost certainly well below the NAIRU, so the tightening would temporarily have to be beyond the long-term equilibrium.
Some FOMC members have argued that a long period of below target inflation should be offset by a roughly equal overshoot – this would be roughly equivalent to price level targeting. The same problem emerges. If we get to, say, 2.3% relatively quickly, the message is that you have to tighten abruptly because you overshot full employment. From an asset market perspective hitting the inflation target means that the friendly central bank is not as friendly anymore. There might be a gain in output but the confidence in the reaction function and ongoing low volatility would be much less.
For asset markets the last seven years have been like heaven, all investor needs being taken care off by a transcendental power who makes sure nothing goes wrong. Hitting inflation targets is getting tossed out of heaven and having to live in the real world that we lived in before volatility collapsed.
In this normal world, central banks tighten at times when the economy is softening because they are much more cautious on stimulus when inflation is on target. This restores the downside to asset market pricing that the central banks effectively removed when inflation was below target.
Similarly, policymaker tolerance for asset market exuberance drops when inflation is at target. They then view rapidly appreciating asset prices as a forerunner of further inflation. Whereas policymaker hands are tied to some degree when inflation is below target, once inflation is at target policymakers are more comfortable acting on asset prices that look out of line.
Bottom line – investors should hope that we keep missing inflation targets, it is the best guarantee of continued asset market robustness. In the limit, as investors we want to get to inflation targets very slowly. Any faster, monetary policy would have to switch from stimulatory to restrictive (not stopping at neutral) before we get to the target. Otherwise the odds are that we overshoot. Once the target is achieved or is in sight, the central bank friendliness to the market is gone, so the forces restraining volatility disappear and asset market risk is more two-sided again.