What Should We Think About the US Stock Market’s Worst Week in Two Years?

By: Inais Black: February 11, 2018, Updated: January 21, 2019

On Friday night, we saw Wall Street plunge 4.1% in a move that rattled markets across the globe. And this was despite the fact that everyone thought America’s economy was out of the woods, so to speak. Then Australia’s stock market followed, tumbling 3%.

So why did that plunge happen then?

It’s worth noting that until last week, the US stock market was more than 300% higher than the lowest point of the darkest hours of the 2007-2008 financial crisis, and it was 88% higher than its pre-crash peak in 2007. This was the second longest stock market boom in history, transcending logic as investors drove the market to new records even as the US economy barely limped out of the crisis. Many investors had been working under the assumption that unusually low volatility and inflation in asset prices would continue, even with above-average growth at a time of low unemployment in America.

And this all comes back to pumped up asset bubbles. “Bubble trouble”, if you will. You see, central banks decided to pump up asset bubbles to revive the global economy, post-GFC, and now they’re trying to deflate them, which is otherwise known as a reduction of monetary stimulus. This is because monetary policy post-GFC in the US, Europe and Japan, sent interest rates below zero for the first time in recorded history, and these countries also printed a lot of new money. All this did was inflate asset prices, from stocks to commodities to property. And when this monetary policy experiment is coming to an end – as it now has in the US, and how it will be shortly in Europe – the markets didn’t know what to do.

Wall Street was already edgy enough as it was, having watched bond traders push market interest rates higher, so when Janet Yellen – in her last appearance as head of the US Federal Reserve – hinted that the American economy may have improved enough to consider raising interest rates, and employment numbers were better than expected, combined with the fact that wages were growing, it was clear that the writing was on the wall; inflation is back.
And investors were spooked, so the market became volatile as people reassessed their previous assumptions.
Now that the pump that artificially inflated global stock markets was gone, it’s safe to say that people reacted. Yields on what should have been relatively safe government securities are on a par, and in many cases superior, to those of much riskier stocks for a while.
So, I can hear you asking, how does this affect Australia?
Well. Here’s the okayish news: interest rates shouldn’t move too much this year. Australian wage growth remains steady (and very low), and inflation figures were disappointing for the second quarter in a row. The Australian market is still around 10% lower than its 2007 peak and our market interest rates are higher than most other developed nations, including the US. Even more importantly, Australia didn’t suffer the same shocks to the economy as other countries did throughout the GFC. We didn’t lower our exchange rates as other countries did.
But that doesn’t mean we’re necessarily ‘safe’, as it were, because the Australian stock market is dominated by two things: financing housing purchases, and mining. The mining boom is now over, and housing finance is moving past its peak, with a definitive slow down in property approvals now happening across the country.
Developers have scaled back plans to build new apartments — particularly in Melbourne and Sydney.

Figure 2 shows us the housing approvals by state and the decline in Victoria and South Australia. Figure 3 shows how Victoria has seen a nearly 60% drop in apartment approvals, with Queensland being the luckiest with their decline of only a few per cent. (Suisse estimates/Reuters)

If you look at Figure 3 above, it clearly shows how apartment approvals by state have declined. Victoria and New South Wales have been hit the hardest, with approximately 50 and 35 per cent drops respectively. Queensland got off the lightest, with only an (estimated) 1-3% drop in approvals.
So we have a slow, but overall mostly stable Australian economy, with a strengthening business sector but a slowing property sector. The housing and apartment construction boom, which was created and fueled to boost employment in our post-mining boom economy, and aided by the immigration policies that have seen a yearly 400,000 population increase, is now past its peak. This, combined with the increasing household debt – now just under 200% for the first time ever – means that the economy is not operating under ideal conditions, but they are conditions that are survivable.
The question the past week has posed, however, is what impact with global economic swings have on us.
The 300-pound gorilla in the room is inflation. If inflation gets away from our central bankers, we will see a hard economic landing in many economies around the World, including Australia. With record high household debt, Australian consumers simply can not afford high-interest rates.

The Australian Bureau of Statistics recently released the Household Income & Wealth Report 2015 – 2016 which includes concerning numbers :

    • In 2015-16, based on the ratio of debt to either income or assets, around three-in-ten households (29%) were classified as ‘over-indebted’.
    • Debt growth has outpaced that of incomes and assets during the same period, helping to drive the proportion of households who are over-indebted up from 21% in 2003-04 to 29% in 2015-16.
    • Among the groups most likely to be over-indebted in 2015-16 were owners with a mortgage (47%), and households with a reference person aged 25-34 (33%) and 35-44 years (34%).

The below graph from that report illustrates nicely the growth in debt over the past 13 years and the acceleration in more recent years:

Graph - Mean household debt in Australia by type of liability from 1984 to 2015-16

Graph 2 (below), also from the report, shows the rapid increase in debt when compared to Income and Assets:

Graph Image for Graph 2 Real(a) increase in value of debt, assets and income, 2003-04 to 2015-16

None of these figures, and in fact the trend for greater indebtedness, in themselves, mean we are facing an economic calamity. We could see huge asset growth and income growth over the next 5 years and all of the graphs and figures here would have become meaningless. What it does tell us, however, is that the Australian economy, and in particular Australian consumers, are in a poor position to handle any significant financial shock in the form of asset prices falling, increased interest rates or falling incomes. However, as Philip Lowe pointed out last night in his remarks to the A50 Australian Economic Forum, “…the quality of lending [has improved]…national measures of housing prices are up by only around 3 per cent over the past year, a marked change from the situation a couple of years ago. This change is most pronounced in Sydney, where prices are no longer rising and conditions have also cooled in Melbourne. These changes in the housing market have reduced the incentive to borrow at low-interest rates to invest in an asset whose price is increasing quickly.

On balance then, from a macro stability perspective, the situation looks less risky than it was a while ago. We do, however, continue to watch household balance sheets carefully as there are still risks here.”

The RBA’s latest economic forecasts, however, remain largely unchanged from those previously announced. The reason for this is that the RBA believes that the Australian economy will grow at an average rate of 3% (or slightly higher) over the next couple of years. GDP should pick up, as show wage growth, although the latter’s movement may remind some – for a while at least – of snails. The unemployment rate has declined to roughly 5.5% (which is good). CPI and underlying inflation are expected to remain at around 2-2.5% (and even lower for underlying inflation).

The RBA believes that this means is that overall Australia should remain safe from volatility in the markets. Other countries may be raising their inflation rates, but just as we did not remain lock-step with them on their way down, we do not have to their way up. Having said all of this, markets sometimes are very irrational, so what ‘should’ happen is not necessarily what does happen.

Sources:

Philip Lowe’s Speech to the A50 Dinner, 2018

ABS’ Household and Income Growth Report, 2015-2016

The Household Debt-to-debt Level is Dangerously unstable

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