Equities sell-off: the start of a new crisis or a healthy correction?
On February 5, Wall Street suffered its worse stock market decline in more than six years after the Dow Jones Industrial Average (DJIA) slumped by 4.6%, the S&P Index by 4.1% and the Nasdaq by 3.8%. In the meantime, the VIX volatility index, gauging fear on US stock markets, reached 50 prior to the opening of US market on February 6, before returning to lower levels (see chart). This peak ends a prolonged period of particularly low volatility. As a result of Wall Street’s decline, Asian stock markets have experienced steep losses in overnight trade. The Japanese Topix fell by 6% at its low point, before closing at 4.4 percent point lower, while Nikkei
225 finished down 4.7 per cent. In Europe, stocks bounced back after an opening decline on February 6, reflecting the growing divergence between European and US assets.
1) On February 2, wage data were released in the US, revealing a long-waited surge in wage growth, after wages increased by 2.9% year on year, the fastest path since June 2009. The importance of such news lies in the fact that wages growth was one of the missing elements to US full recovery. Therefore, following such an acceleration of wage growth, inflation is set to recover, which is likely to lead to a tightening of monetary policy, on a shorter schedule than previously expected. In that sense, the low inflation – high growth scenario on which investors based their valuation of equities could not be taken as granted anymore. This possible
quicker hike in interest rates has pushed up bond yields: on Monday, US Treasury bond yield reached a 4-year high at 2.89%, the highest since 2013 and the taper tantrum (when the Fed announced it will curtail its Quantitative Easing program). Hence, a faster than expected interest rate hike would likely weigh on firms profitability, increasing their debt service burden.
2) Alternatively, this drop in stocks can be understood as a market correction of past stock over-valuation. Indeed the Schiller Index, reflecting price-earnings (PE) ratio has been continuously increasing since the financial crisis, with a steeper rise over the last two years, similarly to what had been seen prior to the Internet bubble explosion in 2000. High level of price-earnings ratio are likely to reflect an over-evaluation of stock returns based on expectations of very high profitability in the future driving up prices while this future profitability is not yet visible in firm’s current earnings. Such rise in PE ratios is particularly evident for new-tech retailer firms such as Amazon, which are expected to shortly takeover traditional companies, particularly among retailers.
An equity market crash may affect the real economy through various ways:
1) lower confidence of businesses and consumer, who areinclined to postpone their investment and spending decisions;
2)negative wealth effects for households and businesses investing in equities;
3) tighter funding conditions as sovereign and bond yields go up.
There is no specific definition of equity market crash but it usually applies to a double-digit percentage decline in a market index within a few days. Against this backdrop, around 20 market selloffs can be considered as equity market crashes in the last 30 years globally. It turns out that their impact on the real economy has been very different from one to another.
Here are 3 illustrative examples (starting with the worst case scenario):
1. The 2007-2008 financial crisis, that started in the US because of “subprime” households and then the Lehman failure in September 2008. It led to a deep recession in advanced economies.
2. The 2000-2001 selloff, resulting from the collapse of the “dot-com” bubble and then September 11 attacks, was followed by a mild recession in the US (i.e. GDP contraction in Q1 and Q3 2001 only). On a yearly basis, GDP growth slowed to 1.0% in 2001 from 4.1% in 2000. The Eurozone was affected with a 1-year lag, as growth
slowed to 1.0% 2002 from 2.1% in 2001.
3. The October 1987 crash, without any significant impact on the real economy within one year.
In our view, a Lehman-type crisis is the less likely scenario, as US households have deleveraged significantly over the past 10 years: US household debt now stands at 77% of GDP, i.e. 20 percentage points lower than in 2008. But the current economic situation has similarities with the 2000 one: 1) high PE ratio, especially in new-tech companies; 2) end of a very long expansion cycle in the US (10 years in the 90s versus 9 years in the current situation). Therefore, if the current downward trend on equity markets lasts, it could be the starting point of a cyclical downturn in the US, and then in Western Europe with a lag.