The Market Collapse Explained

Over the last week, I’ve been speaking with a number of people about what’s been going on in financial markets. People that typically don’t follow the financial markets seem to have knowledge of it’s collapse. But what really happened and why? Here’s my attempt of a simple explanation of what’s been happening and why.

Here’s the last week or so in trading:

We haven’t seen this much market volatility for a long time. Here’s market volatility, a measure of market risk, or what is also known as the “fear index”, since 2008.

Source: MarketWatch

We have not seen market volatility like we are seeing today, since 2011. Investors have been accustom to market calm for 7 years – 7 years, without a bump, and you wonder why everyone is freaking out. Having said this, the level of market risk we are witnessing now is nowhere near the levels we saw in the 2008-2011 period.

So what happened?

On Friday (02/02), the US released employment data that showed not only were more jobs being created, but wages were growing faster than expected. Higher wages means inflation. And too much inflation may prompt central banks, in this case the US Federal Reserve, to raise interest rates. This has investors worried about the implications of higher rates on stocks and bonds.

Why does this matter?

Inflation has a kind of insidious effect. The cost of production rises, company revenues fall as they try and adsorb the early stage rises, and the economy starts to slow until consumers become accustom to a new pricing environment. This can be bad for stocks.

High inflation can be a good thing, as it can stimulate job growth. However, it could also impact corporate profits if company’s are unable to pass on the higher input costs to consumers.

What’s interesting is that since the GFC, we have seen corporations passing on higher input costs not via increased prices, rather, reducing the size of their products, also known as ‘shrinkflation‘.

Investors are also less likely to hold cash during times of inflation, because it’s value decreases over time. It can be a confusing time for investors. It can also be challenging for central banks as they want to ensure some inflation, but not too much.

The last week as has both the bond market and stock market sell of at the same time. This doesn’t happen too often, but it does happen, as I wrote about last week.

What’s the impact on my bonds

Let’s say you purchased a government bond for $100. This bond is paying you 2.50% pa. You’re happy. You can buy more of these bonds, or in fact sell your bond…for $100 (as long as someone is willing to pay you $100).

As inflation rises, so to follow interest rates. Some time passes since you purchased your government bond. The government announces it’s issuing a new bond. It’s worth $100, but they’re now paying 2.75% pa.

Now, if you had a choice of buying two bonds, both worth $100, but one paying 2.50% and the other 2.75% pa., which bond would you buy (not a trick question)? The one paying 2.75% of course. What this means is that if an investor has this choice, they’re not going to be paying you $100 for your bond paying 2.50%. They may offer you $95 for your bond however. And there it is. What investors fear. Loss.

Yes, your the price of your bond can go down (and up too, if rates fall, as we have been seeing over the last decade and more).

However, as long as you hold your bond until it’s maturity, you’l receive you $100 back. Whats more, is that you may be able to buy bonds that are selling at a discount to their issue price as rates rise. And as these bonds get closer to their respective maturity dates, the prices rises, and voilà – capital gain!

A history lesson in stocks

You’d be forgiven for blowing the dust off the history books in an attempt to examine the impact of high inflation and stocks. There have been numerous studies that have looked at the impact of inflation on stock returns. Unfortunately however, the studies have produced conflicting results. Here are some numbers I analysed courtesy of Robert Shiller’s data, which shows us how the stock market has performed given different levels of inflation. The x-axis (horizontal) represents the inflation rate, and the y-axis (vertical) represents the corresponding return in the stock market during that year.

As you can see, trying to find a pattern in the data is very difficult.

 

Source: Robert Shiller data

Let’s take a look at things a little differently.

In the following chart we can see the blue bars represent the average annual inflation for each year during the decade. So we can see for instance that in the years between 1913 and the end of 1919 they averaged 9.8% inflation. That is a high annual inflation rate! The stock market on the other hand generated just over 5% (5.68% to be exact). In the 1920’s, the annual inflation rate was virtually non-existent (actually slightly deflationary at less than 1/10th percent deflation) and the stock market soared. In the 1930’s the stock market had a bad decade and basically finished where it started (after dropping like a rock). So from this chart you can see that there doesn’t appear to be a correlation between high inflation and high stock market returns. If anything there might be an inverse correlation with the stock market doing better during decades when the inflation rate is below 3%. With the exceptions being the 1930’s when there was outright deflation and the 2000’s.

 

The market is worried that the Federal Reserve will have to raise rates much quicker than anticipated, given the surprising data. Here’s why it makes a difference. Bloomberg put together this great chart, which plots the performance of the US stock market during slow tightening cycles (raising rates slowly), and fast tightening cycles (raising rates quickly). And as you can see in the chart below, the performance of the stock market during the two cycles follow a similar path.

Bringing it all together

Since the GFC, interest rates around the world have hit rock bottom. Central banks around the world have been working hard to try and resuscitate a dying economy. Investors seem to have turned a blind eye to the reality of the global economy as they ploughed money into risky assets, such as shares and property – sending the price of risky assets around the world to record highs.

More and more we’re starting to see signs that the global economy is improving – yet the market would prefer an environment of fragility whilst being supported by the ‘invisible hand’ (governments and central banks).

All we’ve done over the last 7 or so years, is anticipate a stronger economy and have brought forward our future gains. Investors need to understand that periods of high growth are followed by periods of low growth, and vice versa. There is nothing new here, yet you’ll be told it’s a “new era”, and that we’ve never seen anything like this before. You’ll hear the saying, “time will tell”, more than you ever have, because no one knows how this is going to play out – don’t be fooled by somebody else’s ignorance. The outcome is not binary. Market’s may continue to rise for sometime, they may meander along, or we may have just seen the beginning of what’s to come.

What is certain however, is that the time will come when rates rise, whether faster or slower than expected. This will be because the economy is heating up. Heating up too quickly for the liking of central banks. And eventually, we will see a real collapse in the price of risky assets, including stocks and property. Like always, it will be temporary, although the market will respond as if it is permanent.

Plan ahead, and pack for your destination, not somebody else’s.

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