The EconomistFebruary 10th 2018 63For daily analysis and debate on economics, visit
Economist.com/economics1E
VERY good horror-film director knows
the secret of the “jump scare”. Just
when the hero or heroine feels safe, the
monster appearsfrom nowhere to startle
them. The latest stockmarket shock could
have been directed by Alfred Hitchcock.
The sharp falls that took place on February
2nd and 5th followed a long period where
the only direction for share prices ap-
peared to be upwards.
In fact the American market had risen
so far, so fast that the decline only took
share prices back to where they were at the
start of the year (see chart). And although a
1,175-point fall in the Dow Jones Industrial
Average on February 5th wasthe biggest
ever in absolute terms, itwas still smallish
beer in proportionate terms, at just 4.6%.
The 508-point fall in the Dow in October
1987 knocked nearly 23% off the market.
Still, surprise rippled round the world.
Between January 29th and early trading on
February 7th, the MSCIEmerging Markets
Index dropped by 7.5%. The FTSE100 index
fell by 8.2% from its record high, set in Janu-
ary. A late recovery on February 6th, in
which the Dow rebounded by 2.3% (or 567
points), restored some calm.
What explains the sudden turmoil? Per-
haps investors had been used to good
news for so long that they had become
complacent. In a recent survey investors re-
ported their highest exposure to equities in
two years and their lowest holdings of
cash in five. Another sign of potential com-nancial markets through low interest rates
and quantitative easing (bond purchases
with newly created money). There was
much talk of an era of “secular stagnation”,
in which growth, inflation and interest
rates would stay permanently low.
But the Federal Reserve and the Bank of
England are now pushing up interest rates,
and the European Central Bank is cutting
its bond purchases. Future central-bank
policy seems much less certain. A pickup
in global economic growth may naturally
lead to fears of higher inflation. The World
Bank warned last month that financial
markets could be vulnerable on this front.
Bond yields have been moving higher
since the autumn; the yield on the ten-year
Treasury bond, 2.05% on September 8th,
reached 2.84% on February 2nd. On that
day American employment numbers
were released, showing that the annual
rate of wage growth had climbed to 2.9%.
That suggested inflation may be about to
move higher. Furthermore, the recent tax-
cutting package means that the federal def-
icit may be over $1trn in the year ending
September 2019, according to the Commit-
tee for a Responsible Federal Budget, a bi-
partisan group. Making such a large
amount of bonds attractive to buyers
might require higher yields.
Higher bond yields are a challenge to
the markets in a couple of ways. First, by
raising the cost of borrowing for compa-
nies and consumers, they may slow eco-
nomic growth. Second, American equity
valuations are very high. The cyclically ad-
justed price-earnings ratio (which averages
profits over ten years) is 33.4, compared
with the historical average of 16.8. Equity
bulls have justified high stock valuations
on the ground that the returns on govern-
ment bonds, the main alternative asset
class, have been so low; higheryields
weaken that argument.placency was the unwillingness of inves-
tors to pay for insurance against a market
decline, something that showed up in the
volatility, or Vix, index. Funds that bet on
the continuation of low volatility lost
heavily (see box on nextpage).
The wobble may also reflect a decision
by investors to rethink the economic and fi-
nancial outlook. Ever since 2009 central
banks have been highly supportive of fi-MarketsBoo!
After a long period of calm, investors get a shockFinance and economics
Also in this section64 Betting on volatility
64 The slide in digital currencies
65 Buttonwood: Index-tracking
66 Insider trading
67 Wells Fargo, capped
67 South-to-South investment
68 Free exchange: Central banks,
technology and productivityIt’s behind you...Source: Thomson ReutersJanuary 2nd 2017=100US ten-year Treasury-bond yield, %2017 201880100120140160S&P 500MSCI emerging markets index2017 20182.02.53.0