The Global Market Rout – Causes and Consequences

This Article was originally published in The Global Analyst

U.S Stock markets have been one of the best performing developed stock markets since the global financial crisis of 2008. A dollar invested at the beginning of 2009 would now be worth $3 (annualized return of 12.9%). U.S stocks went more than 400 days without a 5% drawdown and in 2017 the Dow index registered more than 70 highs. Then what are we cribbing about?

The market witnessed a sudden sell off during Feb 2018. To be precise, the US stock market fell 10.2% between Jan 29 & Feb 06 before it recovered some losses. Though the market is flat for the year so far on a year to date basis, however, the sudden sell off (and the recovery) has created a panic among investors who fear that party may finally be ending. More importantly, the selloff came unannounced as few analysts were expecting this sudden midair bump. In now what is a celebrated quote, Ray Dalio (Co-CIO of Bridgewater) told in Davos just 10 days before the Feb sell off that anyone holding cash will “feel pretty stupid” as they are currently in a goldilocks period.

What caused this sell-off?

U.S is currently experiencing strong growth coupled with lowest unemployment numbers. A combination of these two has instigated fears of inflation (wage inflation to be precise) which will accelerate the interest rate hike cycle (what economists call monetary tightening). While analysts are expecting three rate hikes during 2018 to take the Fed interest rates from 1.25-1.5% to 2-2.25% range, the strong growth and low unemployment has led to the fear of more rate hikes. U.S futures market is now pricing roughly four additional rate hikes through 2020.

After an unusually long period of very low interest rates, economists are now worried that the path to taking the interest rate path back to its normal level may be bumpy and not smooth (what people would want to call as hard landing). In addition, a bull market this long has to pause to catch up some breathe and this can be construed as one. Market commentators have been cautioning about lofty valuations (thanks to the Bull Run) and hence markets have to correct them at some stage.

Also, the sudden spike in volatility has caused a panic. Volatility is best measured through the CBOE VIX index. VIX dropped below 10 to as low as 9.15 on January 03, 2018 which is very unusual in its long history. From those low levels, there was a sudden spike in VIX to 37.3 (Feb, 05) and currently VIX is trading at 20, nearly double of where it closed in 2017. Spike in volatility reveals that the selloff was due to irrational pessimism that exacerbated selling.

The continuous good performance of U.S equity markets (and to an extent global equity markets, as well) and the bad performance of bond markets establishes the difficulty of meaningful diversification. In times like this when equity markets correct sharply, it will be difficult to go and hide behind bonds, which leaves few alternatives on the table.

The outlook for U.S equity markets continues to be positive in spite of this Feb sudden jerk. Investment experts still bet positively on the largest economy of the world running at a good growth clip supported by strong corporate earnings and low unemployment. However, as the Bull Run period gets longer and longer, the probability of a correction (hard or soft landing no matter) increases and this can be a concern for emerging markets like India. When global developed markets undergo corrections, money managers normally reallocate back to home country meaning they will pull money out of emerging markets. Such a retreat from risk assets is bound to have its effect as the saying goes when US market sneezes, all others get cold.

India specific risks are also noticeable at this point. We have widening fiscal deficit that sees no light at the end of the tunnel. The finance minister now considers the long-term RBI target of fiscal deficit at 2.8 to 3.0% as a theoretical target. Re-introduction of capital gains tax after 14 years is considered by foreign investors, as a retrograde step and I would agree with that. The country is still facing GST implementation hurdles though GST is a very positive thing to happen. To top the issues with a cherry is the gargantuan problem of non-performing assets at public sector banks. It is slipping from bad to worse, in its least sense of understanding.

When foreign investors pull money out of India, they have alternatives like commodities (which is experiencing a good rebound). Commodities, metals and mining tend to do well in late business cycle. Unlike equities that vary on anticipations of changes in economic growth and earnings, commodities advance in value as capacity constraints develop. I will not lump crypto currencies into this opportunity basket as they have regulatory risk and its potential to replace existing currencies is minimal.

So, how does the future look? U.S equity markets will certainly test more waters as interest rates climb up. However, the current rise of the markets in the last few years cannot be termed as a bubble and hence we may not have a burst situation. Markets will unwind from its long bull phase albeit with occasional bumps like the one witnessed in February.

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