Why did stock markets fall?

Tuesday’s sharp drop in global stock markets doesn’t make much sense taken in isolation. But the warning signs had been accumulating for a while.

The key question is: is this the beginning of the end of the bull market, or is it just another wobble?

Last year, stocks advanced in much worse circumstances, and it looked like nothing could stop their march forward.

And now, a sharp fall in the price of oil, instead of being seen as a huge tax cut that would boost consumption, is seen as a headwind for equities. Why?

This lack of a logical cause for the big fall in stock markets around the world could be a sign that there are other worries that are coming to the fore for investors.

The main one is the end of the Federal Reserve’s quantitative easing. It has been actually surprising how markets took it in their stride – after all, the Fed had been printing money since 2008.

Now, the markets probably realise that there is a big difference between the Fed – the issuer of the world’s reserve currency – printing money and any other central bank out there.

Yes, the Bank of Japan is buying bonds hand over fist, and all indications are that the ECB will start soon (unless the European Court of Justice throws a spanner in the works on January 14).

But it may just not be the same. Some investors have cottoned on to this earlier than others – which is probably why the big flight to safety started sometime in the middle of last year.

Capital flows

Flows of capital out of high-yield debt into investment grade. Source: Bank of America Merrill Lynch

The chart above shows how capital flows have gradually shifted away from risky high-yield bonds into the safety of investment-grade rated bonds in the second half of 2014.

Equities have recorded total inflows of $11 billion last year, according to a report by Bank of America Merrill Lynch. But that was made up of $44 billion inflows in the first half and $33 billion in outflows in the second half of the year.

Credit bubble burst?

So really, the fear that’s so obvious now started in the second part of the year. The biggest risk out there is the risk of another debt-fuelled bubble bursting.

Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management (LGIM) says that the selloffs in 1987, 2000 and 2008 were “bear markets induced by credit events.”

The end of the Fed’s QE means that debt, particularly in emerging markets, is becoming much more sensitive to sudden outflows. Commodity exporters are particularly vulnerable, because they can be hit by capital flight to safety and see their revenues dwindle because of the lower prices of their exports all at the same time.

China is another region to watch. Although the fall in oil prices is beneficent for China, the country has seen a construction boom on a huge scale, which many analysts have deemed unsustainable.

Now the housing market is cooling off and other areas of the economy are slowing down too, so investors are beginning to worry about China’s debt overhang.

However, as LGIM’s emerging markets economist Brian Coulton notes, the People’s Bank of China – which cut interest rates in November last year – stands ready to do more monetary easing and targeted bailouts may be implemented by the Chinese authorities.

The eurozone’s debt sustainability is “on a knife-edge,” according to LGIM’s European economist Hetal Mehta and “it will not take much to focus the market’s mind on debt sustainability issues in Italy and France.”

But the worries over credit risk are unlikely to derail the markets’ advance over the longer term. LGIM’s outlook for risk assets, especially equities, is positive, since credit risks are “not prohibitive.”

“There is a risk attached to becoming too defensive in a bull market,” van den Heiligenberg notes.

BlackRock strategists concur, although they note that valuations for many asset classes are stretched, many trades are crowded and volatility is on the rise.

They believe the strength of the US dollar is good for Europe and Japan but bad for commodities and emerging markets.

European cyclical stocks may have been excessively marked down because of pessimism over Europe’s recovery so they may be good value, they say. Export-oriented opportunities, which may be sustained by the weak euro, are automakers and German stocks.

They also like Japanese stocks because of the quantitative easing programme there and because the deep-pocketed Japan’s Government Pension Investment Fund shifted its allocation to 25% equities, while an unpopular rise in the sales tax has been delayed.

In the US, they recommend technology stocks, which look attractive for their growth potential, while dividend equities around the world should provide investors with income in an environment of lower yields on bonds.

@AntoniaOprita

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