Worldwide equity volatility spent the six months leading up to the inflection point (the second week of May) near the historically low levels that have been witnessed over the last two years or so.
But between 9 May and 22 May, the Dax lost 10 per cent of its value; the UK’s FTSE100 dropped by 13 per cent. Aside from the effect of aggressive proprietary traders and hedge funds unwinding long trades, there has been little in the way of deteriorating fundamentals that might justify such a correction. It may be the case, therefore, that equity markets have simply been issued with a speeding ticket, and investor psychology has taken over for the time being.
So where will the markets go next? The rise in equity markets over the last three years has not been without temporary setbacks (prices fell through most of last October, for example). This could be another one and markets could regain their poise and push higher in the second half of the year. Ultimately, whether this happens or not probably depends on the economic outlook and this has, unfortunately, grown increasingly uncertain. Equity markets have benefited in recent years from the favourable combination of healthy global output growth and low inflation. Profits have risen strongly but central banks have been able to keep interest rates at low levels – the perfect environment for equity markets. But the economic cycle has now reached the point where strong growth is likely to be seen as potentially inflationary and almost certain to lead to central banks adopting an outright tight monetary policy. This is, at best, a mixed blessing for equity markets. Alternatively, if growth slows too much, profits could fall, which would also undermine equity markets. Furthermore, the risk of slower growth, as a result of past interest rate rises, accompanied by higher inflation, as soaring commodity prices work their way through the system, cannot be completely dismissed. Thus, even if the most likely economic outcome is moderating growth, with inflation and interest rates remaining at relatively low levels, the risks of an alternative outcome now seem much higher. This will make it harder for equity markets to rebound vigorously from their recent weakness and opens up the possibility of lower returns and more volatility in the remainder of 2006.
Tony Dolphin, director of economics and strategy, Henderson Global Investors.
