"It all seemed to be going so well" this year, says Paul Niven, head of strategy at F&C. Just a couple of weeks ago, bankers and brokers were smugly anticipating huge bonuses, thanks to the remarkable performance of the world's equity and bond markets throughout 2005 and especially in the third quarter. Then all of a sudden last week things went wrong. The FTSE fell 1.8% in just one day (the anniversary of the 1987 Black Monday crash) and there was a sudden "blow out in bond markets". And as is usually the case with market moves of such severity and speed, the whole thing took most people by surprise.
But perhaps it shouldn't have. After all, as Jeremy Warner points out in The Independent, "for stockmarkets, October has always been the cruellest month". And if you look at the numbers, you will see that while the drama came last week, worldwide markets have in fact been falling all month. In the first three weeks, the FTSE 100 fell more than 6.5% and over in the US, things were hardly better. In the same three weeks, the Dow Jones Industrial Average fell 2.66%, joined by the S&P 500 and the Nasdaq (3.44% and 4.03% respectively). Around the world, every single major stockmarket has fallen in the last four weeks, from the CAC 40 in France to the Hang Seng in Hong Kong. Even Japan, a MoneyWeek favourite market, at one point last week was down 3% on the month.
But blaming all this on October may be a bit much. While it's true that the worst stockmarket crashes of the 20th century have taken place in October, it is also the case that major indices have gained points more often than they've lost them for the last 33 Octobers. Indeed, some of the more optimistic market commentators even call the month a bear killer', as it has turned around nine of the 18 bear markets we have seen since the Second World War.
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So if it isn't the October effect, what is it? The answer, say the bulls, is simple: the market's current volatility is just down to a little profit-taking. After all, they argue, if you're one of the 3,000 new millionaires supposedly being created this bonus season, thanks to the markets' performance for the first three quarters of the year, you'd be unlikely to chance losing it all just as the year ends. At the beginning of the year, fund managers and traders aren't too nervy. They'll take a risk or two, knowing that if they make a mess of things there will be time to make it all back before bonus time. But by October, time is getting short, so preserving any gains made so far becomes more important than making more. The result? At the slightest whiff of danger, every bonus-hungry employee in the City sells out of all his positions to lock in his performance for the year. But, of course, because they all do it at once, the market instantly nose-dives. This sounds like a reasonable technical explanation for last week's moves, but to suggest that it is a benign explanation is to miss the point. Whatever their reaction was driven by, traders have been spooked this month, so the real questions are what spooked them and, bonuses aside, were they right to react as they did?
The answer to the first question is easy: inflation and the impact it might have on interest rates around the globe. Until recently, it looked as though the battle with inflation had been won in the developed world. But now it is back. While Gordon Brown and the Bank of England fret over inflation going over target to 2.5%, the eurozone is pondering whether to have its first rate hike in over two years as its inflation hits 2.6%, and "America's inflation rate has almost doubled over the past year to 4.7% in September, its highest since 1991", says The Economist. That means that interest rates aren't coming down any time soon. Instead, many now expect a couple more hikes ahead of Fed chairman Alan Greenspan's retirement in January.
And even that may not contain the problem. Until recently, inflation figures had appeared deceptively low for two reasons. First, producers in the developed world were cutting costs. Second, the rise of China as a manufacturing centre meant that prices of hundreds of different goods - from textiles to electronics - were not rising, but falling. These two factors offset the fact that house prices were rising around the world and that the costs of many services were (and still are) rising. The problem now, however, is that both the anti-inflationary effects mentioned above have run their course. The cost-cutting cycle in the West is all but over and prices of imports from Asia are no longer falling, thanks to the fact that costs are rising fast (wages in China are finally on the up, for example, and high oil prices are obviously hitting producers of everything everywhere). No wonder then that "the Fed, the European Central Bank and the Bank of England are suddenly sounding more hawkish", says The Economist. And no wonder that the markets are getting jumpy. Both equity and bond markets hate rising rates: the higher interest rates are, the lower asset prices have to fall for their yields to offer an acceptable premium to risk-free rates to investors.
But higher interest rates have nasty knock-on effects beyond their immediate and obvious disadvantages to the market. Until now, the strong world economy has been relying on the US consumer, and "the US economy has been kept afloat on a sea of debt, both public and private, through the policy of very low interest rates ... This has driven up the prices of all sorts of assets, including dodgy ones", says Roger Bootle in The Sunday Telegraph. One of the assets that has been most affected is US housing, which has seen values soaring - giving people the confidence to keep spending. But that all changes if US interest rates keep rising - which looks a dead cert. "I think a Fed funds rate of 4.5% [from 3.75% today] would be about right. Whether you'd have to go higher than that depends on how the market and economy reacted," says Glenn Hubbard, who was once considered to be a possible replacement for Greenspan at the Fed.
If Hubbard's right, a lot of ordinary Americans are going to have to cut back on their spending sharpish. Not only have their personal debt levels never been higher, but their savings have never been lower, having recently moved into negative territory - meaning Americans as a whole are actually spending more than they earn every month. And what they earn is falling too. "In the past 12 months, average real weekly earnings have declined 1.1% as nominal wages trailed inflation," says market analyst John Maudlin in his weekly letter. All that is holding the consumer up at the moment is the housing market in the US (Americans are still withdrawing equity from their houses as though they honestly believe prices only ever rise) and if this slows - as it soon will - "consumer growth could slow precipitously", says Maudlin, something that will hit the whole world.
The truth is that "how the American economy reacts to this dose of monetary tightening will be the acid test, not only for America, but also for the world", says Bootle. If the American consumer stops spending, it will send shock waves around the world. The emerging markets are particularly exposed, as they have been providing the goods the Americans have been buying.
And the UK will not be immune either. The FTSE tends to follow Wall Street, says Bootle. And as UK consumers have already begun to tighten their belts, falling markets would exacerbate an already difficult situation for the UK economy. Retailers are feeling the pain of the end of the UK housing boom. The mere thought that houses might not just rise and rise has shocked UK shoppers into early hibernation - with the world's biggest consumers, Americans, about to come to the same conclusions. The impact of this on the retail sector has been huge: all over the UK, retailers have been issuing profit warnings as though they were about to go out of fashion. From big-ticket retailers such as MFI right down to Clinton Cards, everyone has been moaning about the state of the market. But with costs going up, and sales going down, it's not going to get any easier any time soon. And the troubles are not restricted to retailers. During the third quarter, profit warnings jumped 39%. Half of the 103 companies that issued such warnings blamed a "difficult market" or "trading conditions", according to a report by Ernst & Young.
So let's go back to our original questions. We know the answer to the first one (what spooked the market), but what of the second - is the market right to be nervous? The answer, it is pretty clear to us, is yes. The bulls aren't giving up easily - in a poll by Barron's this week, 47% of professional portfolio managers are "bullish or very bullish". But if you look at what is happening to inflation, to interest rates and to consumers, it's increasingly hard to take them seriously. It's time to stop blaming October for market volatility and start wondering if the bull market of the last few years might be coming to an end.
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