Explaining the recent tumble in US stocks
America’s economic outlook has strengthened in recent months. Unemployment has stayed low, wages have increased, and economic activity has surged.[1] However, the recent movement in the Dow Jones Industrial Average tells a different story. The current market volatility can be explored by using the Dow, an index which tracks the price movements of 30 large American companies, as a proxy for the broader US economy. If the Dow increases, the general market is considered to be relatively healthy and vice versa. If the Federal Reserve and numerous economic analysts have reported strong economic growth, why are equities struggling to climb out of their current slump?
Interest rate hikes
With strong economic activity and wages growth in the year to February reaching 2.6%, inflationary pressure will begin to be felt. [2] As price-levels grow, it is the responsibility of the Fed to undertake appropriate monetary policy to limit excessive inflation. That’s what happened on March 21st, when the Federal Reserve revealed their decision to hike interest rates. A 25 basis point increase from 1.50% to 1.75% was announced, with hints of further rate hikes to come this year.
This decision could lead two major effects on stocks. Firstly, higher interest rates make it more expensive for companies to issue debt. By choking demand for borrowing and spending, companies are limited with their investments and as a result stifle growth.
Secondly, higher interest rates also raise the risk-adjusted opportunity cost of investing in stocks. Most of us are familiar with the idea – the riskier an asset, the greater the expected return. This is one of the reasons why stock returns, on average, exceed bond returns. Therefore, suppose there are only two asset classes – bonds and equities. If bond returns rise, stock returns comparatively fall, due to the excess return spread of equities diminishing.
Thus, we see investors liquidate their equity portfolio in favour of acquiring bonds, pushing equity prices further down.
Political pressures
President Trump has given the green light to level tariffs on about $50 billion worth of Chinese imports, with plans to slap an additional $100 billion more on Chinese goods. In retaliation, China announced its own tariffs of $3 billion worth of US imports. [3] More worryingly, China’s Washington DC embassy reacted to Trump’s plan by issuing a statement saying China was “not afraid of and will not recoil from a trade war”.
It is these concerns of a trade war that have placed additional downwards pressure on US and global equities. There are no winners in a situation where countries try to damage each other’s trade. Companies would face higher costs for the materials needed to conduct business due to these import taxes and as a result lower their profit levels.
Furthermore, if companies try to pass the cost increase on to consumers, they will face additional complications such as losses in customer base and market-share competitiveness. These factors, wreaking havoc on a company’s bottom line, could potentially add fuel to the fire sale stocks are currently experiencing.
Change in public sentiment
As with most asset classes, stocks tend to fluctuate through business cycles. The Dow rose a monstrous 24.39% for the 2017 calendar year, creating trillions of dollars in wealth. [4]
However, it becomes increasingly difficult to maintain such a trend. As more institutions and investors acknowledge this, the realisation becomes apparent that downside risk (the possibility of a fall in stock prices) starts to outweigh the probability of any further upside potential.
With the assumption of risk averse investors, the rational investor should lock in profits through exiting open positions. This collective mentality, or change in sentiment, acts as a vast supply force, ultimately overcoming any new demand for stocks. Straight from an economics 101 class, we all know when supply outweighs demand for a particular good – stocks, in our case – prices start to fall.
Financial markets are so complex in nature that it is almost impossible to figure out precisely why they move in the manner they do. Despite this, from interest rate hikes, to political issues, or even a simple change in public sentiment, it is always fun to guess!
References:
[1] Gillespie, P. (2018). America gets a raise: Wage growth fastest since 2009. CNN Money. Retrieved 12 April 2018, from http://money.cnn.com/2018/02/02/news/economy/january-jobs-report-2018/index.html
[2] Gillespie, P. (2018). Jobs report surprise: 313,000 added in February. CNNMoney. Retrieved 12 April 2018, from http://money.cnn.com/2018/03/09/news/economy/february-jobs-report/index.html
[3] Colvin, J. (2018). Trump Proposes $100 Billion in New Tariffs on Chinese Goods. Time. Retrieved 12 April 2018, from http://time.com/5230353/donald-trump-china-tariffs-100-billion-chinese-goods/
[4] 2017 Dow Jones Industrial Average Return. (2018). Seeking Alpha. Retrieved 12 April 2018, from https://seekingalpha.com/article/4135186-2017-dow-jones-industrial-average-return
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