Many international financial journals regularly use certain terms to describe the state of equity and bond markets as well as currency movements. To enable local investors to gain a better understanding of the different phases of financial market cycles, I will provide a brief description of some of the more commonly used terms before reviewing recent market developments.
When prices are rallying, the market is said to be in a bull phase. Bull markets are generally characterised by optimism, investor confidence and expectations that the positive sentiment will continue in the near-term. On the other hand, a correction is defined as a temporary decline of at least 10 per cent in an asset class interrupting an upward trend.
A more prolonged correction may lead to a bear market when a price or an index drops by more than 20 per cent. Meanwhile, a stock market crash is a sudden dramatic decline of prices normally driven by panic as a result of major catastrophic events, economic crisis or the collapse of a speculative bubble. There is no specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index or an individual equity over a period of several days.
Last week’s headlines highlighted that the German equity market, generally represented by the DAX30, entered into correction territory after the index dropped by more than 10 per cent from its recent high of 12,374.73 points on April 10, 2015.
German equities had experienced a bull market in the first three-and-a-half months of 2015 as the index rallied by 26 per cent between the start of the year and the high reached on April 10. The index first entered a correction phase on Tuesday, June 9, after it dropped below 11,000 points but after a mild recovery during the following two days, the German benchmark retreated below 11,000 points once again last Monday and Tuesday morning as fears intensified about an exit of Greece from the eurozone.
Many may question the reasons for such a strong start to the year and the sudden correction.
The announcement in early January that the European Central Bank agreed to start its quantitative easing programme in March 2015 led to an immediate upward movement across eurozone equity markets including the DAX30.
This rally continued well into March when the QE programme commenced. Amid heavy buying of sovereign bonds by the ECB, yields plummeted and the value to the euro also declined to a low of $1.05 against the greenback compared to a level of $1.40 in May 2014.
Investor sentiment across the eurozone improved as the ultra-low interest rates and a weak currency boosted economic activity mainly through higher export growth, which led to an increase in the value of foreign earnings of exporters. Some of Germany’s largest exporters – such as Adidas, BMW and Daimler – are among the largest constituents of the DAX30 index and consequently the rally in these equities propelled the benchmark to new record levels.
Meanwhile, the decline in eurozone equity markets including Germany over recent weeks may be due to the recovery in the value of the euro, following the rally in bond yields, as well as renewed fears over Greece. The euro climbed by over eight per cent in a few weeks from a low of $1.0456 on March 15 to a high of $1.145 on May 15. A stronger currency negatively impacts exporters; the share price of BMW, for example, declined by close to 20 per cent since the record high in March and Daimler dropped by almost 15 per cent.
The sudden rally in bond yields since mid-April, despite the ongoing commitment by the ECB to continue with its QE programme until September 2016, is primarily due to the publication of data revealing stronger eurozone economic figures, improved credit conditions as well as indications of an uptick in inflationary expectations as confirmed by the upward revision in the ECB’s inflation forecast for 2015 to 0.3 per cent compared to the previous projection of no movement in prices (0 per cent). Apart from the improving activity across the region, the jump in the price of oil is one of the main reasons behind the upturn in inflation.
Markets will remain on edge and any news, good or bad, can lead to significant swings even within very short time frames
Additionally, the decline over the past 10 days across eurozone equity markets is also due to renewed concerns that Greece may default on its loans and be forced to exit the eurozone. Greece decided to postpone a series of payments totaling €1.6 billion due to the International Monetary Fund by the end of the month. A default would have damaging repercussions for Germany and other eurozone countries which are among Greece’s creditors. Germany and France, the two largest economies in the eurozone, would stand to lose some €160 billion alone from a Greek default.
Following the sudden correction, what should investors expect from the larger eurozone equity markets over the coming months?
Irrespective of how the performance of financial markets will pan out in the coming months, investors should brace themselves for further volatility in all asset classes. We are living in unprecedented times in view of the non-traditional monetary policy tools being used by the ECB (namely its asset purchase programme which is set to run until September 2016), the possibility of Grexit and the divergent stages of the world’s largest economies.
Under such conditions, trends in financial markets and the correlation among different asset classes will be highly susceptible to a number of factors.
Among the most influential is the publication of data across the eurozone, especially that related to inflation and economic growth which could lead to wild swings across bond markets and the single currency as was evident over recent weeks.
Furthermore, financial markets in each region are also very much aligned to the monetary policy of each national central bank. Although various central banks around the world, including the ECB, the Bank of China and the Bank of Russia, are implementing expansionary measures to bolster their respective economies, the US Federal Reserve has already closed off its asset purchase programme and is pondering whether to continue tightening its monetary policy by starting to raise interest rates.
The timing of this is likely to have a significant impact on currencies. A US rate hike in the next few months could result in the strengthening of the US dollar and a correction in US equities.
Meanwhile, a delay could lead to a softening in the US dollar and increased demand for the euro as investors could rotate their investment to Europe in view of the less demanding equity valuations in the region and the improved inflation prospects which should ultimately lead to a gradual rise in interest rates.
The largest turmoil could be created by developments in Greece. This is the first time, since the creation of the euro in 1999, that a European country is close to bankruptcy with the possibility of leaving the single currency bloc.
Given that the numerous possible combinations of outcomes and the extent of contagion across other member states in such a scenario is uncertain, markets will remain on edge and any news, good or bad, can lead to significant swings even within very short time frames.
Given these various factors at play, local investors holding exposure to European equity markets should continue to follow developments closely as they unfold.
Investors should also seek to ride out the inherent volatility across markets and take a longer-term view since equity markets could be supported by continued evidence of a recovery of economic performance and ECB support in the months ahead.
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