Markets are forward looking and when they look ahead into 2019 and beyond, they don’t like what they see.
That’s the fundamental reason for the sell-offs that have rocked investors and taken trillions off the global value of most major asset classes this month.
As an illustration of how large and widespread the sell-off has been, Australian shares are down more than 10 per cent from their most recent peak, US shares are down almost that much, as is the MSCI World share index, China’s market is off more than a quarter from its high point this year, most government bond prices have fallen as yields have climbed and many commodities have also dropped in price.
Pretty much the only thing going up is gold, which is what often happens in times of great uncertainty. Although its 5 per cent rally off mid-August lows is less dramatic than the falls elsewhere.
So why the sudden aversion to risk late in a bull market that has smashed records in the US?
There’s plenty of reasons to choose from. Perhaps the key one is monetary policy.
Rates are rising and will push asset prices the other way
Interest rates are rising, mainly in the US, but also in many developing markets as well.
At the same time, quantitative easing is being wound back, not only in the US but also in Europe.
For the first time in some time, investors are seriously pondering the possibility of something other than a zero official interest rate in Europe, plus less support of financial markets through central bank bond buying.
Ultra-cheap money boosted asset prices, so it is only logical that it’s withdrawal will lower them.
What central banks are counting on is that economies are now strong enough to offset the withdrawal of this monetary stimulus.
There’s little doubt that this has been the case in the US, where growth has been well above average and unemployment at the lowest level since the 1960s, below 4 per cent.
The worry in the US is whether this will still be the case next year and beyond, when the initial sugar hit from corporate tax cuts has faded and as the Federal Reserve continues its inexorable rate rise program.
Australian fund manager Magellan’s co-founder Hamish Douglass thinks there is now a roughly 50-50 chance of a “major correction” in global markets.
“I am very nervous that that is a bet against history in terms of what happens in terms of wages inflation in a super-tight wages market and with the economic stimulus of these Trump tax cuts,” he told The Business.
“The stronger the economy becomes, the more nervous I become that we are going to get a major disruption.”
But, as Citi’s economists observe, it’s not like traders haven’t been well warned that interest rates will rise, possibly quite steeply. They’ve just chosen to disbelieve those warnings.
“For 2019 in the US, there remains a 50-basis-point gap between market expectations of policy rate hikes and the median dot plot [forward rate projections from Fed members],” they wrote in a note.
“There is a significant gap between market expectations for the 10-year US Treasury bond yield as measured by forward rates and by market forecasts.
“These gaps will close — and not likely smoothly.”
The closing of these gaps appears to be a key part of what is happening now, in Bondcano II.
As interest rates rise, higher returns are needed to justify holding risky assets.
If those assets, like shares, are not growing income fast enough, the only way to generate the higher returns is to pay a lower price when you buy them — hence the share market falls.
To borrow a phrase from one of Australia’s most respected economists, Chris Richardson, “gravity has finally caught up with stupidity”.
While he wrote those words in reference to the falling Sydney and Melbourne property markets, the same applies to most of the over-inflated asset prices that are now sliding.
Let the good times roll over
After a few good years of global economic growth, economists are becoming increasingly concerned the good times are about to end.
China’s economy is grinding slower and each round of government and central bank stimulus seems to yield ever decreasing returns for ever increasing debt, with the risk of a Chinese financial crisis looming.
Add to that Donald Trump’s trade war, which risks not only reduced trade and slower economic growth, but also higher inflation as prices rise directly due to the tariffs and indirectly due to supply chain disruptions.
The main threat to eventual European rate rises and the area’s economy now appears to be Italy, where a recalcitrant government insists on spending more than the EU’s rules allow, threatening another split hot on the heels of the approaching early-2019 Brexit.
That is a Brexit that itself hangs in the air or, more accurately, in the Eire — if the UK can’t sort out Northern Ireland’s border with its southern neighbour, then it is hard to see how the split can occur as scheduled.
Europe’s banks are the prime victims of this political uncertainty.
“Its banking sector is in freefall and the number of banks requesting cash (liquidity) from the ECB in its weekly repo [repurchase] operation known as the “MRO” has increased from 25 banks to 45 at the last count, taking the capital requests up from 2.7b to 7.7b euros,” observed Pepperstone’s head of research Chris Weston.
The higher they rise the further they fall?
Perhaps one advantage that Australian equities have in this period is that our share investors have been less stupid even as our property investors succumbed to mass insanity — the ASX 200 index peaked this year at around 6,350, still below its pre-financial crisis high above 6,700.
Australia’s major banks — the biggest component of the ASX — are already off a third from their post-financial crisis peaks in anticipation of a housing correction that is underway and which most economists expect to get worse.
Retailers are battered and most other stocks geared towards the domestic economy have gone nowhere or backwards over the past year or so.
Many Australian stocks are priced for imperfection — one look at the dividend yield the banks are currently returning tells you that investors expect those dividends to soon be cut.
Contrast that to the US, where all three major indices have repeatedly punched through record high after record high — the benchmark S&P 500 peaked this year above 2,900, which was nearly double the 2007 pre-financial crisis peak below 1,600 points.
Investors have been pricing US stocks for continued strong growth, which they now fret is approaching an end.
But while Australian stocks may not have quite as far to fall as their American counterparts, they are likely to keep moving in the same direction as Wall Street — and that appears increasingly likely to be down.