Just like one is told the world is ending every six months, one is also promised a stock market crash in the same time period. Investors today seem too religiously attached to Isaac Newton’s philosophy of “what goes up must come down”, and become over cautious with record-setting stocks. “Crash-happy stock bears” have been the talk of 2016, as experts constantly warn of an immediate sell-off in equity markets and a flow of funds into the bond market.
Since the 2008 financial crash, it is very common for such experts to be trigger-happy with their new angle on why the equity markets are going to fail, which can substantially lead retail investors into making distributional changes to their portfolios. However, professional investors are less inclined to follow suit.
Though 2016 has been a volatile year politically, financial markets have made it through unscathed. For example, the S&P 500 has gradually trended upwards, while the bond markets have experienced little drama due to accommodative monetary policies. Looking forward, are there signs of cracks in a relatively steady worldwide financial market or have markets become immune to external shocks?
Too Big To Fail
The financial crash of 2008 was viewed by the majority as a lesson on giving banks and insurance firms too much freedom in the market. This is true, of course, as US banks had the flexibility to do whatever they wanted, however, they were not allowed to fail in large numbers. Friedrich Hayek was an Austrian free market economist who saw this as the problem. He believed that markets were, in fact, not given enough freedom and that central banks intervening was hurting the economy and financial markets substantially. Hayek believed that the cause of many market crashes was down to central banks lowering base rates so significantly that it effectively created cheap money and thus meant businesses and individuals took on debt they could not afford.
Hayek’s theory could be correlated with how markets are currently operating, due to the extremely low base rates across many of the developed markets. The European central rate, the Fed rate and the Bank of England rate have all been near zero for around seven years, with a possible rate hike being instrumental where the equity and bond markets end in 2017.
These low rates, alongside aggressive quantitative easing throughout the EU and the US, have potentially created a devastating debt crisis. However, in some ways it has become – remarkably – so efficient and competent, that it has hidden from the system it is webbed in. Even more impressive, it is possible one will never see the climax of such a perplexity, thanks to markets being too transparent and too under-invested ever to crash again.
Risk Averse Markets
Liquidity in global stock markets has been declining since 2008, with volumes in the FTSE 100 and S&P 500 both dropping by nearly 50%. Investors are taking fewer risks and seeking less exposure, keeping their cash closer to their chest which is consequently halting any shock to the markets. Investors are also using the transparency of financial markets to expose fewer risks to banks which ultimately sends the burdens of a debt crisis to consumers rather than investors, as consumers are less inclined to commit investment strategies to offset the side effects of high levels of debt in the system.
However, there is still a chance that markets could be affected, and this comes down to two factors. First, a hike in the base rate would make the obliged debt in the system more expensive to hold, meaning, therefore, more businesses and individuals could default on their debt. Secondly, if central banks will be able to carry on effectively purchasing bad debt from the banking industry in Europe, the ECB will inevitably run out of funds to support the cracking banking industry.
This could be decided in March 2017, as that is the date the current series of QE will end. Thus, a decision must be made on whether to allow the banks to adjust and survive by themselves, or to keep inflating the money supply which keeps the banks liquid. However, if the ECB were to halt QE, euro-denominated bondholders would benefit as the euro would likely strengthen due to inflation.
This could have an effect on overall bond prices and create greater demand for euro-denominated bonds, thus pooling funds away from equity into bonds, which could lead to investors shorting on stocks. Though this is likely, it is doubtful the equity will crash but rather experience a steady revaluing.
Inflation Is Set To Change
The equity and bond markets worldwide may need to watch out for the inflation bite as, after years of extremely low prices, inflation looks set to pick up the pace in 2017. The Euro area has started to move away from negative inflation and the US, UK and even Japan are starting to see prices pick up. Inflation can have detrimental effects on the bond market, and as 2016 comes to a close, bond prices are already starting to drop off.
November saw $1trn wiped off the bond market due to President-Elect Donald Trump favouring inflationary pressured policies, whilst 2017 is likely to see the trend continue. This would, therefore, see longer dated bonds such as 30-year yields hit the hardest as they are more sensitive to inflationary pressure. Possible higher inflation in 2017 could also hurt stock markets due to less returns for investors in real terms.
The Real Estate Market
The strength and direction of the real estate market in 2017 could also indirectly affect both the equity and bond markets. China has seen its real estate bubble rapidly increase in 2016, only making the inevitable collapse likely to be more painful in the years to come. In January, China issued a record amount of new loans, equalling 2.51 trillion yuans, most of which went to new homes. However, an increase in interest rates could see this bubble become unsustainable.
The UK is also experiencing a new type of real estate bubble fuelled by cheap money made available by low-interest rates. Due to real estate prices and stock market prices moving relatively in tandem, stock market values are likely to fall if the real estate bubble bursts in 2017.
Financial markets have been relatively stable for nearly a decade now, experiencing slow growth which is likely to remain the same for years to come, as markets have moulded around a low liquidity system. Nonetheless, market declines are still likely, but abrupt crashes are unforeseeable in the near future. Donald Trump’s victory and Brexit effectively tested this new stubborn system, with little continuous downward movement in the equity markets.
The political strength of the eurozone. However, will likely be the decider of the direction of European stocks and Trump’s political path will ultimately decide US stock market valuations. A collapse in real estate in developed economies could offset interest rate hikes in the bond market, as investors are likely to choose safe assets in uncertain times. However, the biggest potential cause for concern is how well sealed the worldwide debt crisis is, which will decide where markets end up in December 2017.