Since the 3rd of October, the FTSE has fallen by around 500 points, from 7500 to around 700 points. This represents a fall of 6.5%, something we had not seen in quite a while. Global stock markets, which move very similarly these days, have all suffered similar losses.
In more recent weeks markets have gone back to climbing slowly and steadily. This recent setback to global equities, while small, has made many investors consider whether a larger correction is set to take place in the near future.
For a while now, there has been an unspoken understanding among most market experts that stocks are overvalued and somewhat of a correction is due.
A simple look at P/E ratios will confirm this. It is not uncommon to see stocks today trading at P/E ratios fo 20:1 or more.
But of course, this could have been said last year too, and the S&P Global 500 index grew at a staggering rate of 20% in the 2016-2017 period.
Nobody wants to be left out of the party, but at the same time, it’s hard to shake off a certain feeling of impending doom.
There are many beckoning questions:
- Are we to expect a market correction? If so, when?
- Is the global economy about to enter another recession?
These are the issues we will try to shed some light on today.
Expectations move markets
What we must understand beyond all things, is that, at the end of the day, people’s expectations of the future are going to determine where markets go today. After all, investing is a long-term game and people are usually thinking 3, 5 and 10 years ahead.
Knowing what people are going to do is probably as good, if not better than actually knowing the “fundamentals” that will in the long-term determine the prices of stocks.
My point is, that a lot of things are going on at the moment, and this is going to push people to react, and probably, overreact. Volatility will probably increase in the next few months, but it’s important to stay calm. The worst thing you can do is get scared when the market falls and sell at a low.
As I like to say, when it comes to investing, like in poker, the right thing to do is often the opposite of what everyone else is doing.
Read: The Great Recession: What Caused the 2008 Financial Crisis?
Politics
While I personally believe politics and finance should not mix, it would be foolish to deny that, in this day and age, political moves affect markets. A lot is going on in this department.
The presidency of Donald Trump has, of course, gotten everyone riled up. While most fears regarding his policies are unsubstantiated there is a real risk that his foreign policy may spike a fully-fledged trade war with China.
Obviously, when the two largest economies in the world collide, the effect can be felt everywhere.
Just yesterday, president Donald Trump announced plans to withdraw the U.S. from a postal treaty that gives Chinese companies discounted shipping rates for small packages sent to American consumers.
While this may seem insignificant, it is only the latest in a series of back and forth blows between these economic powerhouses.
President Trump also placed a 30% tariff on foreign solar panels on January 23, 2018, to be reduced to 15% after four years. China, the world leader in solar panel manufacturer, decried the tariffs.
Trump asked the United States Trade Representative (USTR) investigate applying tariffs on US$50-60 billion worth of Chinese goods, on March 22.[He relied on Section 301 of the Trade Act of 1974 for doing so, stating that the proposed tariffs were “a response to the unfair trade practices of China over the years”, including theft of U.S. intellectual property. Over 1,300 categories of Chinese imports were listed for tariffs, including aircraft parts, batteries, flat-panel televisions, medical devices, satellites, and various weapons.
China responded on April 2 by imposing tariffs on 128 products it imports from America, including aluminum, airplanes, cars, pork, and soybeans (which have a 25% tariff), as well as fruit, nuts, and steel piping (15%).
And so on…
Add to this the increased tensions in Europe over separationist governments (U.K. and more recently Italy), immigration overflow, never-ending problems in the middle east and North Korea…
All together this creates an explosive cocktail ready to blow up in our face.
Rate Hikes and Currency War
One of the problems with globalization is the increased inter-linkedness in markets. This is why, once again, we must look at the actions of the U.S. to understand what is affecting stocks on a global level.
A lot has been said in recent weeks about the Federal Reserve’s rate hikes. I have talked about monetary policy before but let’s have a quick refresher course.
The Federal Reserve, like most central banks, adjusts the supply of dollars (by buying or extinguishing debt) to achieve a desired interest rate. This interest rate is known in the U.S. as the fed funds rate. It is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis. Reserves are excess balances held at the Federal Reserve. This, in turn, affects Treasury yields (the price of U.S. debt), which in turn affects the cost of financing everywhere as U.S. treasuries sit in the balance sheet of most major banks around the world. This is because most countries use dollars to buy oil and settle trade deficits. The interest rate of U.S. treasuries marks the benchmark for “risk-free” returns.
The Federal Reserve has increased rates, something which I personally support, however, there is a concern among investors that these interest rate increases are happening too quickly.
Investors are concerned about rate increases because of two reasons. Firstly, it increases borrowing costs, which can be detrimental to business. Second, and most importantly, increased rates mean higher yields on bonds. Bonds are government debt and, in a sense, they compete with stocks.
The idea is that now that investors can obtain a higher return on “risk-free” government debt, money will be pulled away from stocks, which of course will bring prices down.
Again, going back to our first point. The problem isn’t really that rates are too high now, it is that they could be in the future. Especially if a higher inflation rate forces the Federal Reserve to further “tighten” monetary policy.
In other currency related news, China’s currency, the Yuan, reached a two-month low. This is, in fact, a planned action by the People’s Bank of China (China’s central bank).
As part of their retaliation efforts in this trade war, China continues to devalue its currency to keep its exports competitive.
Currency devaluations are always selfish-moves which do not aid the economy but simply make some lose and other’s win in a zero-sum game.
What should I do?
In times like this, it’s best to ride out the storm. Don’t do anything rash.
The best thing you can do is diversify your portfolio. Buying some countercyclical stocks could be a good idea. These are companies that will do well during an economic downturn.
Also known as recession-proof stocks, these would include the following:
Wine and spirits
In the last downturn, alcohol sales rose along with unemployment. However, not all alcohol companies were affected equally: craft beer and wine & spirit companies thrived while lower-end beers (e.g. Bud light, Natural light, etc), whose customer bases were more tilted towards blue-collared workers (hurt most in the last recession), suffered.
(PBR, SAM, BREW)
Fast food
If you’re out of a job and not optimistic about your near-term prospects, McD’s Dollar Menu will be much better than paying $15 for organic guacamole ingredients from Whole Foods (will help your rainy day funds last longer)
(MCD, BKW, DNKN)
Discount Retailers
In a downturn, TJ Maxx and Ross will outperform Nordstroms, similar logic as the above.
(TJX, ROST)
Auto parts retailers
When strapped for funds, consumers will opt to fix an old car rather than replace it with a new one (delay big ticket purchases for as long as possible)
(ORLY, AZO, PBY)
If you have some cash to invest, I’d consider holding on to it for a bit. It’s impossible to tell what the future holds, but I personally believe a correction is due sometime soon. I’m by no means saying you should sell. The point I’m trying to make is that if a correction does happen, this will be a great buying opportunity(Remember: buy low, sell high)
You can also consider taking advantage of the higher bond yields yourself and purchasing some government debt.
Finally, it might be wise to hold some cash in the form of gold or silver. These commodities always perform well in bear markets.
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