A healthy correction from overwhelming optimism

THE ongoing financial markets correction, coinciding with sharply rising 10-year US Treasury yields and fears of inflation, remains a healthy one. Markets have been overwhelmingly optimistic for some time and a pullback is to be expected.

One of the triggers for selling, ironically, is how the US economy remains very strong. Some 200,000 jobs were created in January, with the unemployment rate holding steady at 4.1 per cent. But markets pounced on a 2.9 per cent year-on-year monthly wage growth, the fastest rise since 2009.

One concern here is that rising wages at the late stage of the economic cycle, without an equivalent rise in productivity, will pressure company margins, as Bank of Singapore chief economist Richard Jerram said in a Monday note.

Another concern is simply that valuations have flown too high, regardless of where interest rates are supposed to be at. Combined with higher expected rates, bond prices will be the first to be hit. Stocks affected include bond proxies like real estate investment trusts (Reits) and utility stocks.

Yet, for a true bear market to arrive takes much more than a strong economy and historically high valuations.

Psychology needs to turn more. For now, while there is certainly nervousness, there is no full-blown panic. The recent correction has barely made a dent in the impressive price run-up since the global financial crisis. Valuations are still at multi-year highs.

Meanwhile, fears of higher inflation leading to much-higher rates are premature. Since the global financial crisis, the US Federal Reserve has been remarkably conservative when deciding whether to raise rates. It will take a few more months of strong wage data before the Fed might even talk about raising rates at a faster pace than what it previously intended to do. Meanwhile, inflation across the rest of the developed world and in Asia is still subdued.

Moreover, the inflation we might be seeing - wage inflation - is coming as a result of economic growth and an economy approaching full capacity. The consequences are stronger consumer purchasing power and more spending. This is surely the good kind of inflation that markets can absorb. By contrast, a bad form of inflation will come from a commodity price spike, or trade wars.

Given how bonds have been arguably overvalued for some time, a sell-off is overdue. As for stocks, the death knell will only sound when there are significant excesses in the economy that will lead to a recession of some kind.

For now, some excesses in the market are deflating. The cryptocurrency bubble is bursting with the help of regulators. Yet one can argue the spillovers into the real economy are limited.

Another excess might more generally be termed as loose financial conditions. It is easy to borrow, and interest rates are still relatively low, even as consumer sentiment in the US is at a multi-year high. The personal savings rate is at a low. Higher rates won't necessarily a bad thing if they remind consumers to be more prudent.

In the region, excesses arguably exist in China's property market, where prices in some Tier 1 cities are now far out of reach for ordinary workers. Yet consensus is that China's government still has all the tools in its hands to manage a real estate slowdown.

Ultimately, it will take a lot more than the threat of rising rates to seriously rattle investors, many of whom are trying to avoid holding low-yielding cash. While the economy looks fine, it is also clear that asset prices have run a bit ahead of themselves.

READ MORE: