Every investor remembers where they were, and what they were doing, in October 2007. If you had investments in stocks, you can’t help but remember it. It was one of those seminal months where the game changed. Overnight, stock markets, which had up to then scaled new heights, were in freefall.
The ASX200 plunged from 6,754 to 5,355 points within six months. By 2009, it bottomed out at 3,344 points. In less than 18 months, the ASX saw 49% wiped off from its market cap.
Yet as you know, this was a global crisis, with global repercussions.
Market panic first hit US markets. In July of 2007, the S&P was sitting on 1,526 points. By January 2009, it plunged to just 797 points.
The worst of the rout was reserved for Chinese markets. The Shanghai Composite Index, (SCI) endured a torrid year. Its peak of 5,954 in October 2007 bottomed out at 1,728 within a year. The SCI shed a staggering 70% of its value within 12 months.
We know what caused all this panic.
The US subprime mortgage crisis set off a chain of events ending in a global recession. There’s a common saying in global finance: when the US sneezes, the world catches a cold. This much was evident back in 2007. And its capacity to influence global markets remains unrivalled.
But we’re now at square one again. This year, stock markets peaked at values approaching levels last seen in 2007. In the case of US markets, they’re higher than they were prior to the GFC crash.
Again, the winds of change are sweeping through the global economy…as they did in the lead up to the collapse in 2007.
So it’s no surprise that investors are wondering whether we’re facing a crash to rival 2007.
Yet it’s not a tech, or mortgage bubble that’s causing anxiety this time. Emerging markets, led by China, are the worry today. The issue is one of growth — or rather the lack of it.
Growth across emerging markets is slowing markedly. That’s a concern because EM’s underpinned global economic growth for most of the past decade. It’s been the only factor countering sluggish growth rates of 2–3% across the developed world.
Yet, as the US makes a habit of doing, even when it’s not directly responsible, it’s still at the root of most problems.
Low US interest rates have created an excess of capital, much of which made its way into emerging markets. Investors, seeking higher yields amid low domestic rates, looked abroad. In the space of six years, economies like China or Brazil were flooded with capital.
But growth across emerging markets has peaked. China, still growing at a healthy 6–7%, is slowing. Investors are pulling money out of EM’s. And there’s also the worry about what this means for domestic growth, adding further pressure on stocks.
The effects of this slowdown on markets won’t have slipped your attention. Every major market, from the SCI, to the ASX200 and S&P500, is on a downward curve.
The recent market turmoil that kicked off in April was a sign of things to come. The ball is in motion, but we haven’t reached the tipping point.
In 2007, there was a clear point at which the pressure of bad mortgages reached before breaking. The same was true of 2000. In 2015, however, the cause of this coming crash is less obvious.
We can point to slack emerging market growth as the potential defining moment once it arrives. But there’s an even deeper issue at hand, and it relates to interest rates.
2016 will probably be the year in which the global fixation on low interest rates dies out. The point at which the era of easy credit ends, and interest rates rise. In history, the start of this movement usually signals an end to market bull runs.
I’ve been looking at stock market crises this century to gauge whether we can learn anything from them. What you’ll find is that there’s a clear link between monetary policy and rising stock markets. Unfortunately, it’s also a two way street. When interest rates rise, stock markets have a habit of crashing.
To explain why, let’s begin by looking at the US stock bubble crashes of 2000 and 2007.
How stock markets move in cycles and trends
I’ll be walking you through three stock markets here. I’ve included the ASX200 (Australia), the Shanghai Composite Index (China), and the S&P500 (US) to illustrate my point about trends and interest rates.
The first thing you’ll notice when looking at these markets is their not all consistent. That might suggest that there’s not much we can gauge in terms of past performances and trends.
But the inconsistency lies between developed and emerging markets. Rather, Aussie and US stocks move more in tandem than those in China.
Take the performances of each of the three markets in 2015 for example.
Both the ASX and the S&P500 hit peaks in January of this year. For the ASX200, the last time it hit 5,891 points was in 2007. The S&P, meanwhile, was actually trending at historic highs in January, at 2,067 points.
The SCI, meanwhile, was still rising in January. It was on a tear, in fact, climbing from 3,234 to 4,611 points by May. At the same time, the ASX and S&P were edging lower.
There’s a good reason for this. And it once again comes down to interest rates. Only this time it was China’s monetary rate policy that made the difference.
Chinese stocks boomed in the first half of this year because of aggressive stimulus measures. The People’s Bank of China cut interest rates five times in the space of eight months.
At the same time it slashed banking capital requirements too. So it’s no surprise that a vast sum of this credit found its way into the stock market.
This helps explain the varying fortunes between Chinese markets, and those of Australia and the US. More to the point, the SCI’s rapid ascent highlighted the immaturity of Chinese markets. Millions of new trading accounts were opening on a monthly basis. Mum and dad investors hold many of these accounts, lacking previous experience in share markets.
But the point here is that Chinese markets are more isolated. At least in the timing and length of their peaks and troughs. But it still follows the global trends that force sharp rallies and declines.
Now, Australia and the US are no strangers to low interest rate environments. The US is, after all, the world leader in this category. US rates, at 0.25%, can’t go much lower without entering negative territory. Even Australian interest rates, at 2%, are still well below China’s 4.65% rate.
Australia and the US are reaching the limits of how far their markets can expand. That’s because credit expansion is hitting a ceiling too. China has been a different story this year though, as it has more room to manoeuvre.
That’s a quick recap of what’s happened this year. But what about 2007? What happened in those months that we can learn from and apply to 2015?
Well, US markets are an interesting case. In particular, what drew me was the effect that interest rates had on US stocks.
The US has seen two major bubbles come and go in the past 15 years.
The first of these was the stock bubble that peaked in January 2000. It had been building rapidly in the five years between 1995 and 2000. Within that period, the S&P500 rose from 500 points to a ceiling of 1,498.
Following the crash, the S&P500 bottomed out at 815 points by July 2002. Yet what happened in the aftermath of the stock bubble crash was important.
US interest started falling. This new injection of credit into the system helped fuel the next bubble. US rates fell from over 6% in 2000, to below 2% by late 2001. Over the following three years, rates edged even lower to 1%. As this unfolded, the S&P500 was picking up steam.
Then, in 2004, rates started climbing again at regular intervals. By 2006, they were back to just below 6%. There was a running theme in which low interest rates helped US stocks perform a U-turn.
As quickly as the stock bubble crash took place, a new stream of credit sowed the seeds of the next bubble. Of course, in this case, it wasn’t just the new credit that poured capital into stocks. Interest rate cuts had both an indirect, and direct, effect on the market. How? Because lower interest rates increased home loan affordability.
Banks lent ever more money to risky borrowers. Once interest rates started going up in 2004, many households couldn’t keep up with repayments. The end result of all this was the subprime mortgage crisis. That’s how we got October 2007. In the case of US markets, it took five years for the process to unfold.
The ASX200 followed a similar pattern between 2003 and 2007. It rose from 2,956 to 6,754 points, more than doubling its market cap in four years.
China’s a little different here because, again, it follows its own logic. There’s no gradual build up taking place. Instead, what you see with China is that it operates in fits and spurts. In the space of one or two years, it can double, even triple its market cap. But it falls just as quickly as it soars. That happened between 2006 and 2008. And it happened again in May of this year, capping the peak of a two year period that will likely bottom out in 2017.
But the comparison between Aussie and US markets is apt.
They both work in a band of between six to eight years. That is, stocks and rise and fall roughly within this space of time. There are of course periods of sharp growth and decline between these years. But the broader trend for both is one in which markets rise and fall within an average of seven years.
The most recent stock market rally started in February 2009. It’s now six and a half years since this upward trend began.
But this year we’ve already seen signs of a broader market decline. The ASX200 is down 700 points since March. The SCI is down 1,600 points. The S&P 500 is down slightly by comparison, though we know why that is. Again, the answer comes back to interest rates.
US interest rates and the future of the ASX
If you recall, US interest started falling in the aftermath of the 2000 stock bubble crash. As the market took off again, the Fed began lifting rates in very quick succession in 2004. Within three years, the mortgage crisis arrived.
There’s a comparison worth making here between 2004 and today.
As we head into 2016, the Fed is deliberating over its rate policy. Yet the question remains one of when, not if, the Fed will hike rates. Once it does, we have evidence of what follows. As rates rise, the market starts to decline, as was the case between 2004 and 2007.
Looking ahead to 2017, rates are predicted to climb sharply. To the point where the tightening of credit strangles emerging markets. And it aggravates the effects of the current global economic slowdown.
The difference between this coming crash and the ones before it is that there’s no one thing underpinning it. Stocks grew in the past six years because of low interest rates, and emerging market growth.
Now that both are heading in the opposite direction, the writing is on the wall for markets. But as we saw in 2004, this process won’t happen in the space of a few months. It slowly unfolds over the course of 18–24 months. The only catalyst necessary now is a reversal in US rate policy.
Markets are too focused on China. And while its economy remains a concern, the direction of its stock market is less important. Which is why you shouldn’t pay too much attention to the routs on Chinese markets. It doesn’t set the trend for Aussie or US stocks. In that sense, it’s somewhat removed even from the Chinese economy…
It’s better keeping an eye on where the S&P500 goes from here.
At some point by mid 2016, it’s likely the Fed will start raising rates. As we’ve seen in the past, a major stock market crash is usually 18–24 months behind.
If the Fed lifts rates by December, or early next year, the great unwind may begin as early as 2017.
Contributor, The Daily Reckoning
PS: The Aussie share market has lost 5% since June, or more than $90 billion in value.
The Daily Reckoning’s Vern Gowdie saw this coming. He predicted the current market correction at the beginning of the year. But Vern says we haven’t seen the worst of it yet.
He’s convinced the ASX will lose as much as 90% of its market cap in the coming months. As China’s economic slowdown picks up pace, volatility will follow.
Vern is the award-winning Founder of the Gowdie Family Wealth and The Gowdie Letter advisory services. He’s ranked as one of Australia’s Top 50 financial planners.
Vern wants to help you avoid this coming wealth destruction. That’s why he’s written this free report ‘Five Fatal Stocks You Must Sell Now’. As a bonus, Vern will show you which five blue chip Aussie companies could destroy your portfolio. You’ll be surprised to learn which banks make Vern’s list…
To find out how to download the report, click here.