After a strong start to 2018, investors may be feeling a sense of whiplash following the events in February. News of strong economic growth bolstered equity markets globally, with US and Asian markets particular beneficiaries of market optimism. So what changed in February?

A change in fortunes

Equity markets reached record highs in January, with the best start to a year for the S&P500 index since 1987. The change in market activity started on the wake of US employment data released on 2 February, which was stronger than anticipated. US payrolls employment data showed the US economy had added 200,000 jobs in January (ahead of the expected 180,000) and wages showed a 2.9% annualised increased. Further to this, US Company reporting season was typically stronger than expected over January. As a result, the US Federal Reserve (Fed) reinforced their view that inflation would reach their targets quicker than expected, which reinforced the markets views that the Fed is more likely to increase the Federal Funds Rate by the stated three times through 2018.

It might seem strange therefore that markets dropped off the back of good news for economic growth, however this change relates more to the recognition of inflation pressures as the economy grows and in turn, the prospect of higher interest rates. Many investors responded to concerns over a changing interest rate environment by moving investments from equities to those assets which they view might benefit from higher interest rates.

Higher interest rates – good or bad?

Higher interest rates can be a positive for some economic and market activities, and inhibit others. Higher interest rates generally mean a higher cost of borrowing money. By example, this might mean higher mortgage or loan repayments. On the other side, it can mean a higher rate of return on savings or bonds. Rates (as part of monetary policy) is a tool used by governments to manage the pace of economic growth and inflation, with lower rates recently used post the Global Financial Crisis to encourage spending and growth and now, higher rates to manage the pace of growth to sustainable levels.

Extending beyond the US

While the selloff in equities started with US activity, it affected markets globally as investors considered the implications in their own markets of higher rates and strength in the US and to companies in their own markets with international revenue streams.

In some situations of share market falls, there can also be a psychological element in investor behaviour. People are uncomfortable in situations where they fear they will lose money, taking fast actions they believe will p reserve their investments from falling further. These decisions might not always take into account the true state of their investments, or their longer-term strategy and can exacerbate the appearance of market activity overall.

In the first week of February, the Australian market fell by 4.6%, European and UK equity markets were down by 4%, Japan8%, China 10% and the US market was down by 5.2%. Yet in the week following, there has been tentative signs of an equitymarket rebound.

How has our share market and the US fared over the last year?

Investors in Australian and US share markets since January 2017 would still have generated a positive return to 12 February2018 despite recent market falls. You can see this in Chart 1.

Volatility to continue?

The rapid movement in the market, also measured as volatility, is somewhat unavoidable for investors. There will always be different events and reactions that drive a spike or fall in the value of investments at different points in time. So how long will this current volatility last?

Below is the US S&P 500 VIX (Volatility index), which is seen as a measure of ‘fear’ in the markets. As is evident from the recent market pull-back, volatility spiked in dramatic fashion, in a similar way to fears attributed to China’s currency revaluation in September 2015, the US’s debt downgrade and concerns over the EU in late 2011, the European debt crisis early 2010, and even the GFC in mid-2008. All these events came and went, with the VIX once again settling and markets moving upwards again.

Forecasting market activity is challenging. It is more than specific events; it also needs to factor human behaviour and psychology, which is often unpredictable. The volatility triggered by investor recognition of strong US growth and what this might mean for interest rates may continue – but equally may settle if investors become more comfortable with what it means and how their investments are priced. It is important to look beyond volatility to the fundamentals of investments– as well as the overall state of economic growth in the world.

A large downward market movement can be commonly seen in a healthy bull market, however the size of the increased volatility in this instance was a surprise. Markets can take time to stabilise so investors might expect some further downward market movements, at least in the short-term. Solid global fundamentals should restore some confidence in the markets over the coming weeks as we go through an adjustment period that accommodates an environment of potentially higher interest rates and higher inflation expectations.

Managing uncertainty in your portfolio.

With uncertainty a fact of life, investors may wonder how best to manage their investments. There are a few things to keep in mind.

1. Be clear on your investment strategy and your goals

   Ensure your investments continue to match with your goals and strategy. If your investments are still right for y ou, short- term changes need not be a major concern.

2. Look to the fundamentals before making fast decisions

   Rather than focusing just on price as a measure of value, particularly with equities, look to the bigger picture such as a company’s current competitive position, cash flows, dividend payment history and growth strategy. Often shares of a company fall simply because the whole market (index) is falling as a result of a broad (macro) market event, rather than the company itself being revalued on its technicals. Making a fast decision in a market downturn may mean you lock in any losses.

3. Diversify your investments

   Spreading your investments across different types of assets, sectors and locations can help reduce your risk of loss. Different investments may perform differently at different points in time.