We may be seeing the beginning of the end of one of the greatest financial stories ever told.
The story began with an over-inflated US housing market in the 2000s. The first major twist came when Wall Street decided to exploit this extremely overvalued market by creating imaginative financial products connected with it.
The next major chapter involved a complete freezing of all global financial markets as trillions in worthless assets were uncovered and, at its core, those making big financial transactions lost trust in one another.
The final chapter has lasted over a decade.
The policy response was to flood global markets with trillions in cheap money. Banks were encouraged to lend to businesses and businesses were encouraged to invest and hire.
It worked to a degree, but too much cheap money also made its way into asset markets — including stock markets.
The final few pages of the story may be playing out before us now, with today’s $63 billion plunge on the ASX another small twist in a global plot. I’ll explain.
A sign the system isn’t coping
In financial markets, sustained rising inflation is one sign the system isn’t coping with the stimulus on offer.
This is especially true in the United States, where a growing economy, huge amounts of fiscal and monetary stimulus, higher wages and cost-push inflation from pandemic supply constraints have led the Federal Reserve (our equivalent of the Reserve Bank) with little choice but to attempt to rein in inflation by raising interest rates.
Today’s Australian inflation data show the Reserve Bank may also be pressured into lifting the cash rate target earlier than it otherwise expected.
While the ASX 200 was already sharply lower before the ABS data came out, it slumped another hundred points soon afterwards and closed around 2.5 per cent down.
To be clear: For now, regardless of what’s driving it, inflation isn’t subsiding, and the higher it goes, the bigger the threat for asset markets like stock markets.
Technology stocks hit hardest
The NASDAQ is a Wall Street index that’s heavily weighted to technology stocks.
It’s already moved into “correction” mode — which is a 10 per cent or more drop in the index from its peak.
Technology stocks, like most stocks, are valued by analysts based on their future earnings.
Analysts try to gauge how much money the company will make six months from now and use interest rates to discount the value of the company to present day value.
Don’t worry too much about how that works now, but suffice to say, these stocks have been the main “victims” in this rout because they are so sensitive to rising interest rates.
The higher the expectation of interest rates, the lower these stocks are valued.
Throw in the threat of war
The problem with years of cheap money fuelling one of the strongest bull runs in history is that it’s come with a lot of stock market speculation.
That speculation has led to some stocks being well and truly overvalued.
“There has been froth with meme stocks, SPACs (Special Purpose Acquisition Companies) and the crypto craze,” AMP chief economist Shane Oliver says.
For the uninitiated, SPACs are companies designed purely to raise money — with no underlying commercial purpose. They’ve existed for decades but have recently raised record amounts of money.
It’s indicative of the speculate fervour in the market.
Dr Oliver adds that “relatively calm years — with the biggest drawdowns last year being 5 per cent in US shares and 6 per cent in Australian shares — are often followed by a rough year”.
So when you throw in a highly unpredictable event like a war, investors’ nerves become frayed.
The threat of Russia invading Ukraine, bloodshed, and all-out war in Eastern Europe is enough to causing a degree of market panic in the type of edgy environment we are in right now.
“So, some are talking of crashes (as they often do),” Dr Oliver says.
Bulls versus bears
The violent – for want of a better word — swings on financial market recently highlight a great fight that’s raging between bulls (those who think the market can go higher) and bears (those that think the market’s set for a period of prolonged losses.
Analysts have suggested that bitcoin may be the canary in the coalmine. It’s fallen roughly 50 per cent from its peak.
But the sheer volume of money switching hands on the trading floor right now suggests an enormous amount of tension within financial markets as to how the next chapter, or final few pages, of the post-global financial crisis story will play out.
Last night, for example, more than $US18 billion in shares changed hands on Wall Street — the busiest session since early 2021.
And the Chicago Board Option Exchange volatility Index rose to just shy of 30. Now it’s well down on where it was during the stock crash of 2020, but it was up 3.5 per cent on the day.
This index level suggests rising levels of fear among market participants — largely because a lot of money is on the line and there’s the potential for many to lose a fortune.
Overnight it was retail or mum-and-dad investors that rushed to the exits on Wall Street, only for the big fund managers to come swooping in at lunchtime for what they perceived to be bargains.
“Equities soared to close slightly up, having been down over 4 per cent — the best bounce seen since the last two occasions we got major central-bank bail-out actions, both back in October 2008,” Rabo Research’s Michael Every noted.
And there really will be bargains if the Federal Reserve chooses to hold off on lifting interest rates until later in the year.
So, where do we land?
Market participants need to work out if looming threats will hurt the valuations of the stocks that make up the indices.
But the trillion-dollar question is whether or not central banks now need to ramp up their efforts to contain rising inflation by materially tightening monetary policy, and raising interest rates.
If they do need to do that, then we are turning the final page in the story of cheap money, and the bears’ roars will be heard reverberating across the globe for some time.
It’ll be a painful re-adjustment for markets. Maybe too painful — in which case the markets will collectively decide to, again, keep pushing to higher heights… until the next shock.
Read More: After today’s $63b ASX plunge, should we be worried about the stock market?