The US 10-year Treasury yield broke through 3.2% in early October. As you can see in the chart below, the downward trend of the last 35 years appears to have been broken.

US 10-year Treasury Yield (1983 to date)

The 10-year treasury yield has increased over the last couple of years as the US economy has continued to grow and consumers have thus become more confident as the financial crisis of 2008 disappears into the mists of time. Inflation though has stubbornly remained subdued thus far, which means real interest rates have moved sharply higher, one of a number of factors that spooked the markets in recent weeks.

Inflation is expected to pick up eventually, a view confirmed by recent reports showing year-on-year US wage growth of 3.1% in October, the highest rate seen in almost a decade. Meanwhile, the US unemployment rate remains at a multi-decade low of 3.7%, well below the rate at which inflation, led by wages demand, has typically picked up.

UK wage inflation is also growing at a 3.1% annual pace but inflationary pressure appears to have eased for the time being. Rates here are likely to rise less rapidly unless greater clarity is obtained about the post-Brexit landscape.

UK Wage Growth (3m Average, Y-o-Y)

Equity Markets

Whilst the US economy remains firmly on a growth footing, (3rd quarter corporate earnings have largely beaten expectations and interest rates remain low), the equity markets have headed sharply lower.  Perhaps this is owing to an uncertain outlook, as forward guidance accompanying recent earnings reports has invariably commented upon the potentially negative impact of trade tariffs: increasing the cost of imported goods and thus crimping margins. This situation would be exacerbated should the US dollar weaken.

A sharp fall in the purchasing managers’ indices in Germany, in particular the export component, served to heighten concern about the impact trade tensions were having on activity. Political concerns were also a feature markets had to digest: the EU commission rejected the Italian budget plan, causing the spread between German and Italian bonds to widen to over 3%. Following a disastrous showing in recent elections, Chancellor Angela Merkel has announced her intention to stand down as leader of Germany’s ruling Christian Democratic Union, but not until her term ends in 2021. The EU central bank also reiterated its intention to end its net asset purchases at the end of the year.

What now?

The fundamental backdrop for markets has not diminished materially. US growth continues, but the current economic cycle is getting old, and late cycle pressures in the form of rising inflation should begin to emerge.  Chinese domestic stimulus is also eagerly anticipated and should improve the outlook for emerging markets.

The risks centre on continued Brexit uncertainty, trade tensions, unpredictable diplomatic spats and a rise in market volatility. Market volatility has been surprisingly low for longer than most expected. A return to more ‘normal’ levels should not only be expected but welcomed, as this invariably throws up some interesting and hopefully profitable opportunities.

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