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Why the Waitangi Day wipeout is no new GFC

The US stock market slumps 4.6 percent on fears of rising inflation and interest rates, but few see it as the start of a new Global Financial Crisis. Bernard Hickey reports.

Is this the beginning of some sort of new Global Financial Crisis and "looming economic correction" that Winston Peters warned New Zealanders shouldn't blame him for when he chose Labour four months ago?

At first glance, it sure looks serious.

The Dow Jones Industrial Index fell 1175 points on Waitangi Day morning New Zealand time. At one stage at around 9.15 am, the index was down 1600 points, its biggest ever points drop within a single day in stock market history. Traders have worried in recent weeks that stock values might have become stretched after rising 44 percent in the 15 months since Donald Trump's election as US President. Some rushed for the exits in late trade and there were some brief signs of panic before a slight recovery later in the day.

Some also worried that tentative signs of wage inflation in the United States might prompt the US Federal Reserve, which now has a new Chair in Jerome Powell, to raise interest rates sooner and faster than previously expected. Slightly stronger than expected US labour force figures on Friday helped drive market interest rates higher, which makes bonds and term deposits relatively more attractive than stocks for savers.

But a closer look at the figures and the wider global economy shows the numbers are not as bad as they seem and the fundamentals underpinning real economies here and overseas are much healthier than they were 10 years ago before the Global Financial Crisis.

The 4.6 percent point fall in the US stock market is a big one in pure index points terms because the index has doubled in the last five years. But the fall was only the 33rd largest in percentage terms. It wasn't even the biggest fall since the Global Financial Crisis. There was a bigger one in August 2011, three years after the market was in free-fall and the global banking system was severely stressed. It's also worth noting the Dow closed at 24,345.75, which still higher than it was two months ago and still 17 percent higher than it was a year ago.

Fund managers and economists said the fall was mostly about some steam being let out of an over-valued market after a 15-month bull run driven by Trump-inspired prospects of deregulation, corporate tax cuts and still-low interest rates.

“It’s like a kid at a child’s party who, after an afternoon of cake and ice cream, eats one more cookie and that puts them over the edge,” said David Kelly, the chief global strategist for JPMorgan Asset Management, speaking to Associated Press.

The US stock market is trading at a price-to-earnings multiple (a bit like house price to disposable income multiples) of around 25 times. That's above the long-run average of 15, but not as high as the 40 times earnings it got to during the dotcom bubble of 2000.

It's different this time

American banks are also in a much stronger position. They are mostly out of trading complicated and often synthetic products in financial markets and have beefed up their capital buffers substantially. There were no signs of stress in credit and inter-bank money markets overnight, despite the sharp fall on stock markets.

Back in 2008 and 2009 when stock and credit markets were routinely moving in amounts similar to that seen in this latest 'Black Monday' slump, the US and global economies and financial systems were in a much more fragile state. The biggest American banks were exposed to leveraged securities linked to the US housing market, which was in freefall, and they had very thin capital cushions.

Banks in Europe were closely connected to these collapsing U.S. banks and were developing their own reliance on a shaky foundation of euro-denominated bonds issued by the likes of Greece, Spain, Portugal, Ireland and France. These banks and European markets were then put under extreme pressure over the next five years as the combined effects of America's housing crisis, its financial crisis and an economic recession in Europe weakened their own balance sheets.

This time around, Europe's economy is expanding finally after trillions of dollars worth of zero interest rate stimulus from its central bank and strong exports to China and elsewhere.

Japan is also in a much healthier position, growing its economy at its fastest rate in 17 years and even generating a little bit of a inflation despite a falling and ageing population. China has stabilised its economic growth above six percent and there are few signs that its heavily indebted (and mostly Government-owned) corporate sector will be allowed to collapse by a Government that controls all the levers in its banking system.

The US economy is also in a much stronger position than it was in 2008. Unemployment has fallen to a 17-year low of 4.1 percent and many expect it to trend down to 3.5 percent. Wage growth is finally picking up too to just under three percent, which is helping fuel solid consumer spending and encouraging companies to invest.

“What we’re seeing right now is an economy overall that is doing quite well and has strong fundamentals,” said Gregory Daco, chief U.S. economist at Oxford Economics. “The economy remains on track to expand at a fairly solid pace, and along with that comes inflation," Daco told AP.

Keep an eye on interest rates

That inflation is the main worry for stock market investors who have gotten very used to very low interest rates over the last decade. They fear that a quick increase in interest rates will spook investors in stocks and slow economic growth.

There are a couple of variables to watch closely here.

Firstly, there's the US Federal Funds rate, which is the equivalent of New Zealand's Official Cash Rate. The US Federal Reserve has increased it just five times since the Global Financial Crisis from zero percent (2008-15) to 1.5 percent now. Financial markets expect around three more moves up to around 2.25 percent over the next year, but are a little more nervous than usual because of signs that wage growth is stirring and because there's a new Federal Reserve Chair who is thought to be more responsive to inflation risks than previous Chair Janet Yellen.

The potential for fast rate hikes is seen as both a potential curse and an opportunity. A quick rise in interest rates could drive markets lower and slow growth, but those interest rate hikes could also be slowed by the US Federal Reserve if it thought they were causing too much grief. It was noticeable that futures prices for short term interest rates reflected an expectation that the Federal Reserve would watch what was happening on financial markets and slow their rate hikes.

Fund managers and traders have learned over the last decade that governments and central banks will bail out banks to stop them collapsing and cut interest rates to stop bad recessions. The same could easily happen again if the markets continued their turn for the worse. Essentially, there is a type of Government guarantee on returns for investors. Rightly or wrongly, this has created a moral hazard that has not been challenged in over a decade. The phrase 'always bet on a bailout' has made a lot of money for investors who avoided running for the exits since 2008.

The second variable to watch is the US 10-year Treasury bond yield, which is the world's most liquid financial market and a good indicator of where financial markets see inflation and interest rates heading. It also sets the basis for all borrowing by Governments globally, including our own. It has risen from 2.2 percent at the beginning of November to as high as 2.90 percent this morning. If it rises convincingly through 3.0 percent and passes its late 2013 'Taper Tantrum' highs then markets and the US Federal Reserve will become more worried, potentially to the point of delaying future short term official rates. The 'Taper Tantrum' describes a sharp rise in 10-year bond yields on fears the Federal Reserve would quickly sell its stock of bonds back into the market. The fears forced the Federal Reserve to slow down its plans to withdraw its stimulus.

The longer-term health of global economies and the potential for more bailouts if it gets much worse won't stop further pain for stock market investors in the short term though.

Australian stocks, which traded normally on New Zealand's public holiday, fell nearly three percent on Tuesday. New Zealand's stock market will be expected to fall too when it reopens on Wednesday.

Winston is no financial Nostradamus

But this is not the start of the economic correction that Winston Peters saw looming on that evening in October when he chose to be in Government with Labour.

New Zealand's own economy is in a healthy shape. Treasury forecast in December that economic growth would average 2.9 percent over the next five years. The Reserve Bank forecast in November that average GDP growth would be 3.3 percent over the next two years.

Despite a sharp fall in headline business confidence in the final quarter of last year when businesses became pessimistic about the uncertainty around a change of Government, consumer spending and businesses' confidence in their own activity has been much more robust. Last week, ANZ reported job advertisements rose 3.1 percent on a seasonally adjusted basis in January from December, which was its highest monthly rise in three years.

BusinessNZ's measures of activity in the services and manufacturing industries edged lower in the December quarter, but remained firmly in expansion territory. The Reserve Bank's measure of consumer lending grew 8.3 percent in December from a year ago, indicating consumers and tourists were confident enough to be spending heavily in the last quarter of 2017 and early 2018. New car sales in January hit a fresh record, rising 7.3 percent from a year ago.

Economists and voters will get a fresh indication of how the economy is traveling on Wednesday when Statistics New Zealand releases labour force data for the December quarter. Economists expect a slight tick up in the unemployment rate to 4.7 percent from 4.6 percent and modest (0.3 percent) jobs growth. This follows surprising strength in the September quarter and a reversion of labour force participation from a record high.

Don't be so sure of spiking interest rates

Then on Thursday the Reserve Bank of New Zealand is scheduled to deliver its first full Monetary Policy Statement of the year at 9 am. It was shaping up as a quiet affair until this stock market slump, but economists expect acting-Governor Grant Spencer to leave the Official Cash Rate on hold and maintain the bank's ultra-easy stance and flat rate outlook into 2019. Inflation is seen remaining low despite solid economic growth.

For those worried about inflation, the Reserve Bank's own preferred measure of core inflation has been flat around 1.4 percent for six years. If anything, the Reserve Bank should be cutting interest rates to bring core inflation back up to around the two percent mid-point in its Policy Targets Agreement and reduce unemployment closer to 4.25, which Treasury estimates as full employment.

The rise of the global tech giants such as Facebook, Google, Apple, Uber, Amazon and Netflix is also pressuring the prices of both goods and services lower all around the world, including in New Zealand. There are structural forces keeping inflation under control, despite solid economic growth.

One example is the decision last year by Procter and Gamble to cut the price of its Gillette Fusion triple-bladed razors by 25 percent because of competition from online firms such as Harry's and Dollar Shave Club.

(Wall Street trading floor photos by Getty Images)

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