Understanding the recent market correction

Didier Saint Georges

Didier Saint Georges

The reason was that both output and inflation were “neither too high nor too low”.

In addition, the European Central Bank initiated its own asset purchase programme a short time later, in 2015.

When the June 2016 Brexit vote sent shockwaves across the financial markets, central banks managed to promptly calm investors by promising to provide whatever support was needed.

And then 2017 gave us the best of all possible worlds. Economic growth was finally on its way up (boosting stock prices in the process), but without a resumption of inflation, which allowed central bankers to go about monetary policy normalisation at a more leisurely pace.

So, the leading central banks are now poised to scale back or even ditch their previous policies. That’s assuredly good news for the economy.

But investors need to realise that the growth drivers they have grown accustomed to are soon to go into reverse. There is no justification anymore for a continuous fall in interest rates.

Central bank intervention had driven them so far down that they were disconnected from economic reality. Interest rates must now move back up to normal levels.

Unfortunately, the Trump administration’s tax cuts have poured fuel on the fire. They will swell the federal budget deficit and force the US government to borrow more – just when the Fed is starting to pull back.

That means there are now two sources of upward pressure on bond yields, before even worrying about inflation.

In Europe, yields on German government paper are quite obviously still far from “normal” levels, even after inching up to 0.75 per cent. 

Financial markets must now revert to realistic prices. Waking from such a pleasant dream will understandably be a new experience.

Once stock and bond prices have overcome the ensuing instability and adjusted to the new reality, investors will need to assure themselves that the economy is still in good enough shape to become the new driver of a stockmarket rally, this time based on sound valuations.

If and when that happens, there might be golden opportunities for getting back in, as we saw after the brutal market correction in October 1987, for example.

However, if the economy were to slow, central banks would have no other option than to apply their recent remedies to restore the markets to good health. Such a U-turn would initially reassure everyone, but it would also amount to a sorry admission of failure.

That is where the real risk lies: if the economy were to still prove too fragile to handle an increase in financial stress, then growth and inflation readings might go into reverse.

We’ll find out only in a few months.