Home Business Q&A: The global stock market sell-off explained

Q&A: The global stock market sell-off explained

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Wednesday saw the beginning of a slump in stock market values worldwide, but what is behind the declines?

:: Why are stock markets falling?

The main reason for the steep falls is because the US Federal Reserve, the country’s central bank, has indicated that it will raise interest rates in the world’s largest economy more rapidly than expected.

That means higher borrowing costs for US consumers and businesses, which could lead to a slowdown in the economy and, for companies with high debt levels, lower profits as their interest repayments rise.

The Fed has raised interest rates three times so far in 2018 and has indicated there will be at least one more increase before the end of the year.

:: But why should that hit markets elsewhere?

Higher US interest rates suck money out of other assets around the world and back into US assets – depriving other economies of capital.

That is a particular worry for some Latin American economies, for example, if investors demand a higher premium for putting their money there rather than in US assets.

In addition, a lot of borrowing in emerging markets is denominated in US dollars.

When US interest rates rise, the dollar becomes more attractive to hold, while other currencies fall in value in relation to the greenback.

In emerging markets, when the dollar rises, then the cost of servicing and ultimately repaying that debt goes up (when expressed in their local currency) for people, businesses and governments who have borrowed in dollars.

:: Anything else?

There are an awful lot of things for investors to be concerned about just now.

The biggest thing keeping investors awake at night is the risk of an intensification in the trade war between the US and China.

It has exacerbated fears that the rate at which the Chinese economy is growing has slowed down.

That is bad news, for example, for the mining companies that sell China the raw materials that power its economy or for German manufacturers who supply Chinese industry with machine tools.

It’s also terrible for countries like Vietnam that have a very close trading relationship with China. Other factors of concern to investors are the risk of a “no-deal” Brexit, signs of a possible clash between the EU and Italy over the latter’s refusal to set a responsible budget, and the US midterm elections.

But the relationship between the US and China is the biggest concern.

And, overlaying all that, is the inexorable rise of debt. The International Monetary Fund’s latest report reveals that global debt stood at $182tn (£137tn) at the end of 2017, representing a 50% increase over the past decade.

If other economies raise interest rates like the US – or even start to withdraw the fiscal stimuli put in place after the financial crisis – that raises the cost of servicing and ultimately repaying debt for a lot of borrowers.

:: Was some kind of sell-off inevitable?

Absolutely. Another very important factor to bear in mind is that we are now at the end of a very long running cycle in which stocks have risen inexorably upwards.

The current bull market in equities is now in its 10th year in both the US and Europe. At some stage, a correction was inevitable. It is no surprise whatsoever that the most violent falls in stocks in recent days have been in stocks that have enjoyed the most spectacular gains, most notably US tech stocks like Apple and Amazon, but also the likes of Fever-Tree Drinks in the UK, which has lost a third of its market value during the last week.

:: What’s been happening in the bond markets?

The bond market is readjusting its expectations of US interest rates.

Yields (which rise as the price falls) on 10-year US Treasuries have surged from 2.853% at the end of August to as high as 3.261% earlier this week.

To put that in context, US 10-year yields have not been that high since May 2011. US Treasuries have a particular impact on the US housing market because most US mortgage rates are priced off, and move in response, to bond yields. Higher bond yields have a knock-on effect to the so-called “real economy”.

:: Donald Trump has said the Fed is “crazy”. Is he right?

Not really. The US economy is on a tear and US corporate profits are strong – partly because of Mr Trump’s tax cuts, which led a lot of American companies to bring money back to the US that had been kept offshore.

Unemployment is at just 3.7% – a level barely seen in the last half-century. The US economy grew at an annualised rate of 4.2% in the second quarter of the year. The Fed is acting perfectly rationally in assuming that raises a risk of higher inflation and raising the cost of borrowing accordingly.

:: What’s the relationship between bonds and stocks?

Normally, bond and equity markets have an inverse correlation. If stocks are in demand, investors will tend to switch from bonds to equities, sending bond yields higher. If stocks are out of favour, investors tend to switch out of equities and into bonds, sending yields lower.

:: Hang on – recently we’ve seen both stocks and bonds falling?

You’ve put your finger on one of the most worrying aspects of the recent shake-out in markets.

It’s rare to see both stocks and bonds falling at the same time. Potentially it could hurt investors who have sought to diversify risk.

Bond yields rising is usually a sign that the economy is growing strongly, that investors are putting their money into stocks instead and that interest rates are set to rise in response to higher inflation.

This increase in yields is more reflective of the fact that the US budget deficit is starting to increase (partly thanks to Mr Trump’s tax cuts) and so US investors may be demanding more of a premium to hold US Treasuries.

That said, US Treasury yields have eased back during the last couple of days as stock markets have fallen, suggesting the relationship is reverting to normal.

:: OK, now I’m really scared.

If you want to be really scared, take a look at Mr Trump’s track record.

In business, he liked to borrow a lot, describing himself during the 2016 presidential campaign as “the king of debt”.

On at least four occasions during his business career, when debts threatened to overwhelm his businesses, lenders were forced to take a haircut on their loans to him.

Since becoming president, Mr Trump has shown a willingness to adopt tactics he used in business, such as an aggressive approach to haggling over trade deals and taking an “I win, you lose” approach rather than the traditional attitude to free trade deals which is that everyone wins.

Reneging on the US national debt would be a logical progression – albeit a terrifying one given that US Treasuries are the most widely-held asset in the world.

Would Mr Trump dare do that? Well, in May 2016, he said this to CNBC: “I would borrow knowing that if the economy crashed, you could make a deal. And if the economy was good, it was good, so therefore you can’t lose. It’s like you make a deal before you go into a poker game. And your odds are much better.”

No one is suggesting that Mr Trump is going to walk away from America’s debts. But the thought that he might is starting to fray a few nerves.

(c) Sky News 2018: Q&A: The global stock market sell-off explained