The February sell-off ended market complacency and highlighted serious challenges ahead for equity investors.
A period of stronger economic growth is generally a positive driver for equities, but inflation can erode corporate profits. While the unexpected acceleration of US wage growth in January was not sustained in February, it reminded investors that the risk of inflation is rising as the spare capacity in the economy is absorbed. As a result, the Federal Reserve could decide to act proactively with regards to inflation by increasing interest rates more aggressively than currently anticipated.
In addition, drivers other than inflation and Federal Reserve policy have the potential to push US yields higher. The US tax reform is expected to widen the US government deficit1 by US$1.5tn over the next decade, which in turn will require an increase in government funding. The resulting additional supply of US Treasury bonds coupled with a reduced demand from central banks, as they simultaneously prepare for unwinding quantitative easing, will also add upward pressure on bond yields.
The rise of interest rates is likely to negatively impact equity valuations (equity prices typically decline when bond yields rise). The S&P 500 Index valuations are currently slightly above their long-term historical average for periods of interest rates hovering around 2.5%, as illustrated in the graph below.