The week between Monday 5th February and Friday 9th February 2018 has not been an easy one for stock market investors. All major stock markets in the world seem to be ‘crashing’, or at least going through a correction. Since 26 January this year, global markets have lost $5.2 trillion!
That’s $5,200,000,000,000! So what caused this turbulence and should we be worried?
What triggered the fall in stock markets?
Stock markets started declining all over the world last week after the U.S. economic data showed stronger-than-expected results on wage growth and employment. Let’s try to understand why.
Shouldn’t a strong U.S. economy be good news?
Rising wages and lower unemployment means people will have more money to spend. This usually results in higher inflation making prices of goods and services go up. Investors do not like inflation.
Interest rates have been at record-low levels since the 2008 financial crisis. This was done to encourage spending and investment to help the economy recover. However, interest rates cannot be kept this low forever. This can have many negative effects.
When unemployment falls and wage growth increases, governments may see this as an opportunity to increase the interest rates to tackle inflation.
Why are higher interest rates a problem for investors?
Stock markets do not like interest rate increases because it makes borrowing money more expensive. This in turn affects the spending power of borrowers – consumers and businesses.
Secondly, we saw a global sell-off in the last few days of government bonds causing an increase in bond yields. Bond yield is the amount of return for an investor who buys the bond. Higher bond yield gives higher return.
Rising interest rates make current low-interest government bonds less attractive to hold. With more sellers and fewer buyers for these government bonds, their prices start plummeting – i.e. their yield goes up.
As bonds are considered lower risk investments than stocks, when the yield increases, investors start moving their money from stocks to bonds. This further causes stock prices to decrease which contributed to this week’s decline.
So why is everyone talking about volatility?
The reason everyone seems to be discussing volatility is due to the extreme events that happened this week.
Volatility describes the degree of change (increasing or decreasing) in the price of any financial product such as stocks.
In the 1990s, the Chicago Board Options Exchange launched the CBOE Market Volatility Index or VIX, aimed to be the indicator of market volatility and help investors manage their investment risks through ‘hedges’.
However, in the 2000s, the CBOE introduced the ability to trade the VIX index itself – effectively allowing you to ‘bet’ on whether the market volatility will increase or decrease.
Earlier these trades consisted of a very small part of the industry but is a big market today, with around $8 billion in assets. Due to a long period of relatively low volatility, significant bets were placed on it staying low or going lower.
When volatility spiked unexpectedly this week, these bets unravelled spectacularly. For example, Credit Suisse’s XIV (reverse VIX) lost 92% of it’s value on February 6th.
Economists have argued whether the VIX should continue being used as a sign for market volatility, or if it has been corrupted by these ‘bets’ being placed on it going up and down i.e. investors report lower volatility because they have bet on lower volatility.
Having said that, volatility was caused by market events last week, not vice versa.
So should we be worried about another financial crisis?
First of all, no one can guarantee whether the market will go up or down in the future. However, it’s worth noting that 5-10% corrections in stock markets are quite normal. While uncertainty exists, there doesn’t seem to be any sign of a prolonged financial crisis yet.
Given the recent activities, markets are expected to be volatile in the upcoming days. The tug-of-war between interest rates and inflation will make the global stock markets react in interesting ways in the short to medium-term future. However, as a long-term investor, I am waiting to see how the market reacts when inflation and interest rates actually rise further. As long as they rise in line with market expectations, I am not too worried about minor corrections along the way.
The article was originally published on The Millennial Investor