Zombies and the new volatility
The ‘Goldilocks’ days of cheap money are coming to an end, Eddie Ford looks at the consequences
Last week saw $4 trillion wiped off the value of markets around the world in a two-day orgy of panic selling. At one point, Wall Street was 10% down in a record fall. Though it started to rally again by February 9, the Dow Jones Industrial Average, or index (which measures how 30 major US companies have traded) fell 5% over the week in one of the biggest drops since the 2007-08 financial crisis. The more broadly based S&P 500 and the tech-heavy Nasdaq also experienced a turbulent few days, dipping low and then recovering - only to fall again.
World stock markets have dropped sharply from recent record highs. However, somewhat perversely, but with its own logic, the markets plunged downwards for the same reason that they rose so steadily throughout 2017: ie, brighter economic news. The trigger for the sell-off was a US labour market report showing more jobs being created, wages going up and unemployment at 4.1%.
But actually the statistics are not quite what they seem. Most of the beneficiaries of wage growth were those in senior positions, whilst annual earnings growth for those in “production non-supervisory” positions (the bottom 83% of the jobs market) were only 2.4%. As for the 4.1% jobless rate, this disguises the fact that labour market participation has yet to get back to where it was at the start of the great recession a decade ago. In reality, America’s employment rate is currently just over 60% - that is, 3% lower than it was in 2008.
However, regardless of detailed statistical interpretation, the markets knew that the jobs report would add further pressure on the Federal Reserve to take tougher action by raising interest rates in order to head off potential inflationary pressures. The era of cheap money is beginning to come to an end - something that really spooks the markets. Last year shares were bought by the gazillion because it was thought the US was in for a prolonged period of strong growth, weak inflation and low interest rates. But this year everything is starting to look different - stronger economic growth now seems to be regarded as an unwelcome development.
Reflecting this expectation, or fear, there was a jump in the yield on 10-year US treasury bonds - they were up to their highest level since 2014, rising from 2.61% to 2.9% by February 12.1 Commenting on the wild ride of the past few weeks, Peter Cardillo, chief market economist at First Standard Financial in New York, said the volatility was likely to continue - this was “typical of a market that has not yet fully corrected”.
In other words, stock markets are now 10% down from the highs they reached in late January - what goes up must come down, or be ‘adjusted’. A ‘bull market’ cannot last forever. They would, however, have to fall another 10% for them to enter a ‘bear market’ - a condition in which securities prices fall and widespread pessimism causes the stock market’s downward spiral to be self-sustaining. Between 1900 and 2015 there were 32 bear markets, averaging one every 3.5 years. The last coincided with the global financial crisis, occurring between October 2007 and March 2009 - the Dow declined a staggering 54% during that period. Various financial analysts have suggested that the ‘correction’ in equities could last until March - maybe even slightly longer.
Naturally, during this turbulent period, the volatility index (or Vix, also known as the ‘fear index’), which measures the stock market’s expectation of change, spiked sharply. In the words of Chris Weston, chief market strategist at the IG online trader in Melbourne, a spike in the fear index “means there is no confidence about going out and filling your boots with stocks”. That is because “you could wake up and the Dow is down another 1,000 points, or it could be up”. Weston added: “Markets like certainty, but the only certainty at the minute is of a big move and that could be up or down.”
However, what is as near to certainty as you can get is that a hike in interest rates is coming soon. After all, there is only one way they can go, given that they have been at a historic low for an almost unnaturally long period of time. The US Federal Reserve is universally expected to begin raising interest rates in March, and similarly the Bank of England has strongly signalled that hikes are coming very soon: Threadneedle Street issued a statement saying it would need to raise rates to tackle stubbornly high inflation “somewhat earlier and by a somewhat greater extent” than it had anticipated towards the end of last year.
It goes without saying that most investors want the era of cheap borrowing to continue indefinitely, no matter how fantastical the notion. With low interest rates, they have been able to borrow and invest on the cheap, particularly in the assets that for the past decade have gone up every year by much more than their salary - property and shares. Countless businesses have also come to rely on low borrowing costs to keep going, and investors fear they might go bust, should their bank raise loan rates. Obviously, many investors will simply sell their shareholdings if it looks like there is no more magically cheap money to be had.
More generally, weaning companies and investors off their addiction to cheap money is going to be an uphill task - even 10 years after central banks first put their stimulus packages in place to stop the global economy tanking and despite repeated warnings that these measures would have to come to an end. For some, the good times will soon be over.
Of course, for many the good times never really happened - and they are now set to get worse. Obviously, a sudden increase in interest rates will adversely hit millions of low-income families, who have only managed to survive financially for the last decade by utilising various forms of relatively cheap credit. According to a recent study by the Resolution Foundation, the proportion of households in some form of “debt distress” rose to 45% among the poorest fifth of working-age households - with more than a third experiencing difficulty in paying for accommodation and one in six in arrears on either their mortgage or consumer debts. Households headed by someone aged 25-34 spent nearly £1 in every £5 of their pre-tax income on debt repayment. Levels of consumer credit have soared in recent years to more than £200 billion, prompting debt charities to warn that lenders are repeating the mistakes made in the early part of the century, when households on low incomes were sold loans they could not repay.
Forecasts from the Bank of England last week showed that inflation and rising wages were likely to cancel each other out this year, leaving poor households trying to cope with higher interest bills.
At Davos three weeks ago, Christine Lagarde, director of the International Monetary Fund, said the global economy was doing better than expected pretty much everywhere. At the same time she warned that this recovery had left out large numbers of people and was not based on particularly solid foundations. “There is also significant uncertainty in the year ahead,” Lagarde said. “The long period of low interest rates has led to a build- up of potentially serious financial sector vulnerabilities.” Then, speaking in Dubai on February 11 in her first public comments since the market turmoil, Lagarde stated she remained “reasonably optimistic”, but cautioned that “we cannot sit back and wait for growth to continue as normal”.
Putting it slightly more forthrightly, Bob Prince, co-chief investment officer for Bridgewater, the world’s biggest hedge fund, remarked that there had been “a lot of complacency built up in markets over a long time”, and, as a result, he did not think “this shakeout will be over in a matter of days”.2 Indeed, he continued, “we’ll probably have a much bigger shakeout coming” - perhaps entering a bear market, or worse? Meanwhile, Bridgewater’s founder, Ray Dalio, struck an even gloomier tone at Davos - saying the markets were still in a “Goldilocks” period, but warned that the current cycle was in its “final stages” and would be acutely sensitive to shifts in expectations for interest rate increases. Prince reminded his audience that last year equity markets had a “free run”, but this year “we are going from central banks contemplating tightening policy to actually doing it” - thus there will be more volatility, as “we are entering a new macroeconomic environment”.
Echoing these sentiments, the Financial Times informs us that volatility is “here to stay” - the “illusions” of the past years have become “exposed” (February 12). Yes, the paper argues, the economic backdrop or “fundamentals” remain positive: growth is “solid and broad-based”, policy stimulus is “ample”, financial conditions are “still very easy” and the risk of hyper-inflation is “low, given muted wage gains and price expectations”. But, having said all that, the FT notes, the recent market ructions have revealed “the cracks in the foundation of the rally in riskier assets, such as stocks” - the outcome being that an “elevated concentration of risk” in low-volatility strategies that are sensitive to the level of interest rates “has met its nemesis in the form of a vanishing backstop from central banks”. This signals “more pain for investors’ portfolios, as they adjust to a more normal rates and volatility environment”.
So volatility is expected to remain for the next period - lots of ups and downs, with individual firms or even whole sectors going bust. In fact, a large number of companies operating up and down the country are zombie capitalist firms - Carillion was a good example. The latter was essentially a giant Ponzi scheme, financing this project with the ‘advance’ from the next, and so on. That was made possible by the ability to borrow money very cheaply (plus state largesse). We should expect that various companies of this nature, which have just about managed to survive, will eventually go bankrupt - something we might have seen in 2007-08 if interest rates had not been cut to rock-bottom.