Another painful day for markets yesterday.
All the major markets saw significant falls. A few hundred points here, a few hundred there, and pretty soon you have yourself a proper correction.
Before Christmas, everyone was talking about melt-ups and how there were no clouds on the horizon. Barely a month later and there’s an emerging markets crisis and investors don’t know where to turn.
So what’s gone wrong?
2014 has been miserable for most stock market investors so far.
Two main reasons are being thrown up: China is slowing down, and the Fed has stopped printing money. But these aren’t terribly satisfying explanations on their own. China has been slowing down for at least 18 months now, if not more, and the Fed has been threatening to ‘taper’ since last May.
What was the tipping point? What’s got the market so rattled now?
Well, no one rings a bell at the top or the bottom of the market. But if you look at what’s been going up and what’s been going down, I think there’s a pretty clear explanation for why everyone’s suddenly nervous again.
People were clearly too bullish before Christmas, so they had all their bets placed on one outcome – a smooth reflation, driven by the geniuses who run the world’s central banks.
Then, post-Christmas, we ran into some weak economic data that contradicted that happy story. It’s not about China’s weak data; China is a wildcard – its entire financial system could implode. But you could have said that in just about any year in the past five, at least.
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The real problem is the US. The jobless data was awful in January, and manufacturing data yesterday was atrocious. And yet the Fed continued to ‘taper’ cheerfully, without even mentioning a hint of doubt about the process.
Now, a lot of this bad data could be down to the disruptive winter they’ve had in America, so it may not represent anything significant.
But the story investors have been telling themselves is this: it doesn’t matter that the Fed is tightening monetary policy, because the US economy is getting better. Up until now, investors have been betting that the real risk is that the Fed is ‘behind the curve’ – that the recovery will pick up, inflation will leap, and there will be a ‘sweet spot’ where everything jumps in price before the Fed has to take drastic action.
So buy equities, sell bonds, and sell gold (because things are looking up for the financial system). Ditch your ‘safe havens’ and start piling into ‘risk’.
That trade has now reversed. Equities are bombing, while bonds – last year’s big casualty – are rising. Even gold has rallied, along with the gold miners.
You see, if the Fed is tightening monetary policy, but the US isn’t actually in the throes of a spectacular recovery, then that could leave monetary policy too tight.
Now, the idea of the Fed running ‘tight’ monetary policy may make you chuckle cynically – I’m practically giggling at the notion even as I write these words – but you have to remember that investors have grown used to the Fed stepping in the minute there’s a hint of a correction.
With quantitative easing (QE) dropping off, and economic data disappointing, what will prop up equity prices?
In short, this is a market that is worried about deflation. When you’re worrying about deflation, you buy bonds – they pay a fixed income, which will only rise in value in deflation. You buy gold – deflation is very disruptive to a debt-based financial system, and the ‘opportunity cost’ of holding gold during deflation is minimal.
The next crisis is not about deflation
So how long will this last? Is this ‘the big one’? Another 2008?
I have to say, I don’t think so. I can understand why investors are worried about deflation. But I don’t see this being allowed to carry on.
One of two things will stop this rout, I suspect. We could get a run of better data out of the US, which will bolster confidence once again. That may or may not happen – the next big release is on Friday, with the latest US jobless data. That could easily be affected by wintry weather, leaving the markets panicky again.
So the dud data may continue. But if that happens, either the Fed will pause the taper, or the Bank of Japan will decide that it can’t allow the yen to strengthen any further, and so it’ll print more money.
At that point, everything will rally hard, and it’ll be fun and games again.
I might be wrong. But generals are always guilty of fighting the last battle. The deflationary crisis of 2008 was the last battle. I believe that the next crisis will be an inflationary one – and that central banks will do everything in their power to make sure that this is the case.
So I’d stick to drip-feeding your money into your chosen markets, and just enjoy the current opportunity to buy more stocks for your cash.
(If you’re new to building a portfolio, I’d suggest you take a look at my colleague Phil Oakley’s Lifetime Wealth letter. Phil shows you how to build a complete portfolio, designed to withstand most economic conditions, and talks you through key concepts such as rebalancing, keeping costs down, and looking at your savings goals. You can find out more about it here.)
And if there’s an emerging market you’ve had your eye on, then now could be a good opportunity to start putting some of your money to work. I wrote about some of our favourites recently – if you’re not already a subscriber, you can get access to the piece and get your first three issues free here.
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A new structured product gives you exposure to the housing market without buying property. But think twice before handing over your money, says Merryn Somerset Webb.
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