The stock market has been misbehaving in 2018, and the erstwhile pattern of 2 to 3 percent corrections followed by new highs has been broken. First, there was a 12 percent mini-crash, then a rally, then another drawdown—and no new high, at least not yet.
Most pundits think this is just a repeat of the more volatile times, as in 2011, 2012, or 2016, when stocks corrected more than 10 percent, then went off to new highs again.
“Turn off CNBC. Go to exercise class. Read a book. This market pullback was expected and very much needed to happen for the market to go higher. … No need for defensive action,” Jonathan Torrens, president of TCM Wealth Advisors, told WealthManagement.com.
However, the world in 2018 is different from that in 2016, and investors have plenty of reasons to be concerned this is the start of something worse than just a 10 to 20 percent drop in the main stock averages like the S&P 500.
Economic data overall is pretty robust, but this isn’t necessarily a good sign. GDP growth and unemployment are always good at market tops and so are corporate earnings. The stock market is a leading indicator of things to come, not the other way around.
Valuations and sentiment indicators are still stretched at bullish extremes, as they have been for the last several years, so this itself cannot be the decisive factor for the market downturn (even though the “Goldilocks” summit at the World Economic Forum this January set this year apart in terms of euphoria—also notable at market tops).
“We are in this Goldilocks period right now where we have had this beautiful deleveraging. Inflation isn’t a problem. Growth is good, everything is pretty good,” said Ray Dalio, the founder of the world’s largest hedge fund Bridgewater Associates, at the forum in Davos.
Follow the Money
Of course, impeding trade wars are a real concern, but the most important influence on stock prices—and other asset prices—has turned decidedly negative.
It is money and credit. The more money there is in the financial system, the lower the interest rates and the higher stocks go, because there is more money buying them. Thanks to the Federal Reserve’s and other global central banks’ quantitative easing programs throughout this decade, money and interest rates have always favored asset prices. In 2018, this has finally changed.
The Fed had been raising rates for two years, with the latest hike in March making it to a relatively respectable 1.75 percent. It has also started to shrink its balance sheet, albeit by small amounts. The European Central Bank and the Bank of Japan are still in expansion mode, but are lowering their asset purchases. All told, global central banks are in tightening mode and more importantly, credit markets are starting to feel it, with negative impacts on bonds and stocks.
The most important interest rate in the world, namely the 3-month London Interbank Offered Rate, or LIBOR, doubled from 1.15 percent one year ago to 2.3 percent on March 27, as high as it was during the worst days of the European debt crisis in 2012. The only time it was higher was during the last financial crisis.
LIBOR is the rate banks charge each other on short-term loans, and it is the reference rate for trillions of loans and mortgages worldwide.
“LIBOR is still the reference point for the majority of leveraged loans, interest-rate swaps, and some mortgages,” wrote Citigroup’s Matt King, in a note to clients. “In addition to that direct effect, higher money market rates and weakness in risk assets are the two conditions most likely to contribute towards mutual fund outflows. If those in turn created a further sell-off in markets, the negative impact on the economy through wealth effects could be greater even than the direct effect from interest rates.”
In short, higher LIBOR means it’s harder for banks to source dollars because of central bank tightening. And although some analysts note that the blowout in LIBOR is isolated and due to U.S. firms repatriating U.S. dollar cash to domestic banks, thereby withdrawing funding from the market, there are other canaries in the coal mine.
The Hong Kong dollar, for example, which has a fixed exchange rate to the dollar, is hitting the lower band of the trading range set by the Hong Kong Monetary Authority (HKMA). Recently, it has traded as low as 7.84 to the dollar, lower than during the China tremors in 2016 and the financial crisis of 2008. The lowest allowed level is 7.85, at which point the HKMA directly intervenes in the market.
“This is the result of ample domestic liquidity, which has kept local interest rates low as those abroad have risen, and isn’t a sign that the peg is under strain. Nonetheless, the limits of the peg’s flexibility will soon be tested and interest rates will rise,” wrote research firm Capital Economics, in a note to clients.
In other words, the rising rates in the United States are putting pressure on the HKMA to also tighten monetary conditions.
In the United States itself, the rates are having an impact on everyday people beyond the obscure world of LIBOR as well as the HKMA.
According to Black Knight Financial Services, 30-year fixed mortgage rates are climbing toward post-recession highs of 4.5 percent. This not only means that fewer people will be able to afford to buy a house, but also that as of February, 1.4 million people with a mortgage no longer have the incentive to refinance and save on interest expenses.
Higher rates and too much debt are also the reason smaller banks in the United States—those not in the top 100—have seen their bad credit card debt skyrocket to 7.17 percent at the end of 2017, a tad below the high point of the last financial crisis.
All this is worrying for the stock market, as it has depended on functioning credit markets and ample liquidity to conquer new highs time and again since the depths of the Great Recession. And to be fair, whenever the going got tough, as during the U.S. downgrade crisis of 2011 and the European financial crisis of 2012, global central banks came to the rescue with another quantitative easing program.
But there were many instances in the past when central banks continued to tighten into a recession, and over-reliance on their micromanaging the economy cost investors their shirts.
“It may be well again to stress the all-important point that the Federal Reserve has it in its power to change interest rates downward any time it sees fit to do so and thus to stimulate business,” observers read in the magazine Financial World in April 1929.
We read the same lines again 89 years later. And with Jerome Powell and not Ben Bernanke or Janet Yellen at the helm, it looks like it could be 1929 or 2008 all over again.