Topsy-turvy rea­sons for the global stock sell-off

With the US Dow Jones slump­ing 5pc, in­vestors are tak­ing fright, but the three-decade long bull run might not be over just yet

The Daily Telegraph - Business - - Business | Comment - Ben Wright

For many it will feel that the lat­est mar­ket sell-off has come out of the clear blue sky. Aren’t we be­ing told that the global econ­omy – and the US in par­tic­u­lar – is do­ing pretty well right now? Why then are eq­ui­ties tak­ing fright – with the US Dow Jones In­dus­trial Av­er­age plung­ing nearly 1,400 points in two days and trig­ger­ing hefty falls in Asian and Euro­pean mar­kets?

The slightly Won­der­land an­swer is that eq­uity in­vestors are wor­ried pre­cisely be­cause the global econ­omy is in such fine fet­tle.

Let’s fol­low the bread­crumbs back­wards. We are now three decades into an eq­ui­ties bull mar­ket. In­vestors have been telling them­selves that it has to end at some point. There has been a great deal of de­bate about whether eq­ui­ties are over­val­ued. On some mea­sures they are; on oth­ers they aren’t. Ul­ti­mately, which side you come down on is prin­ci­pally a mat­ter of faith. And faith is a frag­ile thing.

One of the driv­ing forces be­hind the surge of eq­uity in­vest­ment in re­cent years has been a scarcity of al­ter­na­tives. In­ter­est rates have been held on the floor by global cen­tral banks for the past 10 years as they at­tempt to re­sus­ci­tate their economies fol­low­ing the fi­nal cri­sis. This made in­vest­ing in a whole host of debt prod­ucts – whose prices are in part de­rived from in­ter­est rates – ex­tremely unattrac­tive.

Peo­ple of­ten for­get that the global debt mar­ket is al­most twice as big as the global stock mar­ket. Imag­ine a party held in two rooms, one twice as big as the other. If some­one turns off the heat­ing in the big­ger room, the smaller room is soon go­ing to get pretty crowded.

In re­cent weeks the heat­ing has been turned back on in the big­ger room. Yields on debt prod­ucts, es­pe­cially gov­ern­ment debt and US Trea­suries, have started to rise. The yield on 10-year US Trea­suries nearly hit a seven-year high on Wed­nes­day.

They are tak­ing their cue from global cen­tral banks – and es­pe­cially the US Fed­eral Re­serve – which have started to raise in­ter­est rates and in­di­cated that they would like to raise them fur­ther. In­vestors are also look­ing at the eco­nomic in­di­ca­tors that Fed of­fi­cials will be us­ing to gauge how quickly to hike rates. And what they are see­ing is scar­ing them: the US econ­omy is show­ing signs of turn­ing red hot.

Unem­ploy­ment is plum­met­ing. This is, of course, a good thing. But it might re­sult in com­pa­nies fac­ing higher labour costs and this is, in turn, stok­ing in­fla­tion. Some com­men­ta­tors have pin­pointed the pro­ducer price data, which was re­leased on Wed­nes­day and sug­gested no let-up in in­fla­tion­ary pres­sures, as the main trig­ger for the re­cent sell-off. If this con­tin­ues, the Fed might have to hike rates faster than an­tic­i­pated in or­der to cool things down. This would re­sult in com­pa­nies fac­ing higher bor­row­ing costs and lower rates of growth in the fu­ture.

Part of the rea­son the US econ­omy is over­heat­ing is that Pres­i­dent Trump has en­acted such an ex­pan­sion­ary fis­cal pol­icy, cut­ting taxes and pledg­ing bil­lions to be spent on in­fras­truc­ture. He is now be­rat­ing the Fed for try­ing to dampen the ex­u­ber­ance with rate hikes. This could be likened to a man set­ting fire to his house and then shout­ing at the fire brigade for turn­ing up with a hose.

Trump’s fis­cal poli­cies are not the only prob­lem. The lat­ter stages of the multi-decade bull mar­ket have been led by the big tech­nol­ogy stocks. Ama­zon’s shares have risen about 50pc this year; Net­flix is up about 70pc. These, along with in­dus­trial stocks, are start­ing to be hurt by the in­creas­ing trade ten­sions be­tween the US and China.

Added to this is the sense that tech stocks might not be per­pet­ual growth ma­chines as some in­vestors ap­peared to be­lieve. The tra­jec­to­ries of some are lev­el­ling off as they sim­ply run out of new cus­tomers to sell to and ex­ist­ing cus­tomers start to ques­tion their per­va­sive­ness. This is not good news for stocks that are priced to grow at nose­bleed rates in per­pe­tu­ity.

What now? We’ve wit­nessed sim­i­lar “ta­per tantrums” in re­cent years when the Fed tried to raise rates and the mar­kets had a hissy fit. Janet Yellen, the pre­vi­ous head of the Fed, ba­si­cally spent her en­tire ten­ure get­ting the mar­kets com­fort­able with the fact that in­ter­est rates would have to rise at some point.

But the hikes have only been ex­tremely grad­ual so far. They have boosted yields a bit, but then in­vestors have moved from eq­ui­ties to bonds, yields have fallen again (as they move in the op­po­site di­rec­tion to price), and eq­ui­ties have started look­ing com­par­a­tively at­trac­tive again. This has kept the lid on pre­vi­ous sell-offs.

The dif­fer­ence this time is that the Fed might have to hike fur­ther and faster. The ques­tion then will be whether the Fed is able to ig­nore the an­guished cries from the mar­ket and the fu­ri­ous tweets from the Oval Of­fice. Which is it more wor­ried about: a stock mar­ket cor­rec­tion (which is ar­guably long overdue) or ris­ing in­fla­tion?

If it’s the for­mer, then the cur­rent dip may just be what mar­ket par­tic­i­pants would call a “buy­ing op­por­tu­nity”. If it’s the lat­ter, things could be about to get ugly.

‘One of the forces be­hind the eq­uity in­vest­ment surge was a scarcity of al­ter­na­tives’

‘Tech stock tra­jec­to­ries are lev­el­ling off as they sim­ply run out of new cus­tomers’

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