The first two months of 2018 have served as a wake-up call to investors who have grown used to steadily rising asset prices and low volatility. Global equity markets experienced a peak-to-trough fall of close to 10% in sterling terms, and volatility briefly spiked back to levels last seen in the global financial crisis.Since the lows reached on February 8, equity markets have recovered and by the end of February global equities, as measured by the MSCI All Countries World Index, were off just 0.6%. However, sterling assets have struggled more - with the FTSE All Share down 5.1% in the first two months of the year and UK government bonds 1.8% lower.
Investors, including us at Flying Colours, are now re-evaluating a bull market that has been supported by low borrowing costs, modest economic growth and benign inflation.
The first thing to say is that market setbacks are normal. While negative returns are undesirable, they are a part and parcel of investing and something all investors must accept.
So far, the drawdown has been limited, and we note that it could get much worse. What triggered the sell-off was a re-evaluation of global inflation expectations following very strong wage growth data in the US. This, in turn, led to a fall in bond prices (and rise in bond yields) and subsequent falls in equities.
It is signs of higher inflation that is one of the key factors we are watching. The ten year US breakeven inflation - which is the inflation rate implied by the US inflation-linked bond market - is now back above 2%. Clearly, the market is pricing in inflation reverting to more normal levels, at least over the long term.
The second, and perhaps more important factor, is valuations. Today, after a near decade long bull run in equities and an even longer rally in bonds, valuations are looking stretched. An S&P 500 price to earnings ratio of 26x, while the FTSE is trading at just a nudge over 20x - both of these are well-above long-term averages.
Fixed income markets are also looking pricey. Yields remain low and with three to four interest rate rises forecast for 2018 in the US, bond markets look susceptible to potential falls.
While risks are rising we would end on a note of positivity. On balance, we believe the sell-off in early February was a correction rather than the start of a bear market. For a true bear market to occur, the world typically falls into recession and economists have been upgrading their global growth forecasts, not cutting them.
Tax reform in the US is acting as a form of economic stimulus and seems certain to have prolonged the current business cycle. A recession this year - and perhaps even in 2019 - seems unlikely.
Guy Myles Chairman, Flying Colours Investment Committee