Why financial markets blow up at exactly the wrong moment

published 24 November 2015

151124-stock-markets — It won't take much to send markets tumbling

One effect of quantitative easing across the globe has been to make investors rather careless about who or what they invest in.

With money easy to come by, the notion that a company might go bankrupt, and that this is something you should consider before lending to or investing in it, has become rather quaint.

After all, even if you decide you'd rather stop lending to a given company, there is always some mug around the corner to take the debt off your hands.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

But it's starting to look like the supply of mugs is drying up

Stability leads to fragility

Nearly two thirds of those are in the US. And you can probably guess which sector is suffering the most: energy and natural resources.

The collapse in the oil price driven by Saudi Arabia's desire to bankrupt the US shale oil producers, whatever the cost to its own exchequer has taken a heavy toll on the sector.

Investors who remained willing to pump money into struggling shale producers this time last year, believing a bounceback was only a matter of time, are less confident now that the oil price has been hammered so hard, for so long.

The rise in defaults has driven up the yield on corporate junk bonds in the US, from 5.6% at the start of 2014, to 8% now, according to the FT. Again, most of the real stress is in the resources-related sectors, which yield an average of 12% now.

Now, clearly we've been in an unprecedented environment for bankruptcies in that there have been very few of them. And by the standards of the olden days', the current and forecast number of future defaults remains "muted", as Dian Vazza of S&P puts it to the FT.

The tricky thing about stability though as Hyman Minsky taught us is that it breeds instability. Markets have a tendency to push things until they break. So even in the most benign environment, all that happens is that they get careless.

No one defaulted last year, goes the thinking. So why would they default this year? And if no one defaulted last year, well, who needs all these protections? And who needs a high yield? It's all going to be fine anyway.

Of course, when everyone thinks like that, all you're doing is piling risk on top of risk. The structure of the market becomes ever more vulnerable, and eventually you reach a point where you don't need a massive shock to send the whole thing toppling over pretty much anything will do.

As a result, says Vazza, "the current crop of US speculative-grade issuers appears fragile and particularly susceptible to any sudden or unanticipated shocks".

The most destructive side-effect of constant central bank intervention

If you don't allow the market to have a clear-out sometimes, and you don't allow it to discipline bad habits (bad habits such as lending to companies that are in serious danger of going bust), then you aid and abet the creation of this ever-more precarious structure.

It's moral hazard' again it's not a terribly fashionable view, but it's the one that makes most sense to me in light of human behaviour.

So how are markets that are conditioned to the Fed and co always stepping in to save the day going to react to higher interest rates, should they be forthcoming? I'm not sure they'll be as relaxed as everyone hopes.

Already we've seen plenty more wobbles in the market as the dollar has re-embarked on its bull run, following the Fed's commitment to raising rates in December.

And weird things are happening across the entire bond market we'll have more on this in the next issue of MoneyWeek magazine but it largely boils down to the lack of liquidity in the markets.

Meanwhile, we have a slow but steady escalation in the chaos in Syria and the threat on our own doorstep. This morning I've seen that Turkey says that it has shot down a Russian warplane that entered its airspace. (No wonder the defence stocks mentioned in our MoneyWeek cover story at the end of October have seen near double-digit gains already).

In short, if you're looking for avalanche triggers there are plenty of them about.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.