Q&A: Why are stock markets falling and will it do permanent damage?

 
Jasper Jolly
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Scratching your head over the latest sell-off? (Source: Getty)

Investors around the world are feeling the pain of big sell-offs in equity markets as volatility spikes to levels not seen since a flash crash in 2015.

The FTSE 100 fell by 1.7 per cent, while European shares on the Stoxx 600 index were down 1.85 per cent at the time of writing. That came after Asian markets were hit by big losses, with Japan's Nikkei 225 down by 4.73 per cent, the most since 1990, and Hong Kong shares dropped by 4.77 per cent.

Why is this happening now?

The turmoil began at the start of last week, when the S&P 500 stopped its relentless march to new record highs. That was driven by increased expectations of inflation in the US, which in turn could force the Federal Reserve to raise interest rates faster than markets had priced in, increasing borrowing costs for companies.

But the trigger for the more dramatic moves came on Friday, as US payrolls data showed average hourly earnings rose by 2.9 per cent in the year to January, the fastest since 2009.

That prompted a two per cent sell-off on Wall Street for the first time during Donald Trump's presidency, followed by a four per cent fall on the S&P 500 last night.

Are inflation concerns justified – and is Trump to blame?

It would be surprising if inflation did not start to rise eventually, given the trillions of dollars of monetary stimulus pumped out by central banks – indeed, policymakers are desperate to start returning interest rates to "normal", wherever that may be.

Inflation has certainly started to pick up, resulting in the paradoxical effect of a stronger economy prompting investors to sell shares.

Meanwhile, the policies of Donald Trump have added some further fuel to the fire, with his stimulative tax cuts expected to be inflationary.

Do increasing borrowing costs pose a threat to the financial system?

The International Monetary Fund and the Bank for International Settlements have been among the prominent economists who have warned that one of the biggest risks to financial stability comes from the possibility of higher inflation. That would raise bond yields and could theoretically cause an overwhelming wave of higher borrowing costs for companies.

Firms have enjoyed almost a decade of easy money as central banks tried to lift the global economy out of the doldrums, so some investors are concerned that the recent spike in bond yields could put a brake on earnings growth.

However, analysts believe the current increase in borrowing costs will not start to hurt firms. The yield on the US 10-year Treasury bond has risen to highs above 2.8 per cent, but companies would only start to hurt if rates for firms rise to around four per cent, economists say.

Isn't the global economy doing fine though?

Yes. Global growth has reached its strongest level since the financial crisis, with the Eurozone in particular enjoying an unexpected boom in 2017.

Some economists, such as those at the World Bank, think that global growth could slow in 2019 – although equity markets rarely look that far ahead. The simple fact is that sustained share price gains are rare, and when they happen the potential for market sentiment to turn quickly can build up.

"The available evidence suggests this is simply a correction of excess investor exuberance as opposed to anything more sinister," said Abi Oladimeji, chief investment officer at Thomas Miller Investment. "Investors should remember that economic growth remains robust."

The outlook for the global economy remains "strong and vibrant", says Markus Stadlmann, chief investment officer at Lloyds Private Bank. The current correction "could last for a while" with US equities previously reaching an "overvalued extreme", but the outlook remains strong.

Should people buy the dip?

If the underlying fundamentals are still strong, then surely people should actually be buying now?

"It takes bravery and perhaps a bit of stupidity" on a day like today, says Simon French, chief economist at Panmure Gordon, but looking at economic indicators there is "no real sign" that growth is slowing.

Steven Andrew, a multi-asset fund manager at M&G Investments, says: "From a fundamental standpoint little seems to have changed. Increasing wages should ultimately be a good thing for the US economy and corporate profits.

"These considerations, and the rapid nature of price [movements] suggests that there may be some non-fundamental drivers of this price action, and our predisposition would be to add equity exposure."

Why are currency markets unaffected?

In all of the turmoil, the currency markets have remained relatively calm – a situation which feels unusual after two years when sterling and the dollar were the main barometers of political ructions.

Yet there are actually few reasons why currency markets should be affected, says Jeremy Cook, chief economist at payments firm World First. He says: "This seems to be a Wall Street not a Main Street issue, and until it hits funding markets that could meaningfully affect credit in the short term, as in 2007, then currencies should remain above the fray.

"The Japanese yes, the US dollar and the Swiss franc have picked up on some 'haven-ing' overnight and we would expect that to accelerate if the bloodletting continues as the US reopens.”

Read more: FTSE 100 follows Asia and Wall Street in third day of global equity rout

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