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Markets have woken up

Investment | Shares

By Justin Modray, published 05 August 2011.
Helpful? 30

You could argue it's about time markets fell, what's taken them so long?

I haven't written much about stock markets recently, mainly because I don't think much has fundamentally changed for some time now. The underlying problem that has spooked markets this week isn't new, it's been around for at least a couple of years...

The problem

Many countries have been spending far more than they're earning, borrowing money (usually by issuing government bonds, e.g. gilts) to cover the shortfall. This is fine if the country concerned can afford the interest payments, it's no different to buying a new TV on your credit card with a view to paying it off over a few months (or years in the case of governments).

Problems start when the interest payments (and/or repaying existing loans that become due) rise to the point a country needs to borrow more money to help pay them - it can create a vicious circle. This needn't be a catastrophe shorter term provided the country can continue to borrow money at reasonable rates, with a view to paying down debt as fortunes improve. But when lenders (typically banks and large investment funds who buy government bonds) fear a country might struggle to pay the interest and/or the money lent, they'll demand a higher interest rate on new bonds to compensate for the added risk, which might push the affected country to breaking point - prompting the EU/IMF or similar to step in with a bailout package (usually an expensive loan) - Greece being a prime example.

Bailouts can work, but if things are severe then the country concerned might still struggle to make ends meet and eventually have to 'default' on its debt - that means not meeting interest payments and/or not repaying money owed to bondholders - similar to going bankrupt. This is bad news for bondholders (e.g. banks) as they'll almost certainly lose some, if not all of their money, causing ripples (or tidal waves) around the global financial system.

If a country is to reduce borrowing to a sensible level it needs to start earning more than it spends, paying down debt with the 'profit'. This means earning more money (i.e. growing its economy/raising taxes) and/or cutting spending - trouble is the two seldom go hand in hand. For example, the UK is trying to grow its economy but spending cuts and tax rises appear to be thwarting the process - it's like trying to swim against the tide.

The table below gives an idea of where things currently stand for a few topical countries:

CountryDebt/GDPCentral Bank Interest Rate10 year Government Debt yieldGDP Annual Growth (latest)
UK 77% 0.50% 2.7% +0.7%
US 60% 0.25% 2.5% +1.6%
Germany 79% 1.50% 2.3% +5.2%
Spain 64% 1.50% 6.4% +0.8%
Greece 144% 1.50% 15.4% -5.5%
Ireland 94% 1.50% 10.6% +0.1%
Italy 118% 1.50% 6.3% +0.8%
Portugal 84% 1.50% 11.5% -0.6%
Japan 226% 0.10% 1.0% -1.0%
Debt/GDP source: CIA/Eurostat

GDP effectively represents a country's annual income, so a high debt/GDP ratio is usually a bad thing. But what really matters is the cost of borrowing. Japan's debt is a colossal 2.26 times higher than its annual income, but as debt interest (shown by debt yield) is low at 1% it's affordable debt. Contrast this to Greece where debt is 1.44 times higher than GDP but debt interest is a whopping 15.4%.

How does all this affect stock markets?

In several ways. If a country defaults on its debt then banks around the world (who own that debt) are likely to suffer, pushing down their share price. So when fears over defaults rise then bank share prices fall in anticipation of the worst. Debt problems also spark fears that austerity measures will cause consumers to spend less money and reduce energy consumption, pushing down oil prices (hence oil company share prices) and hurting the outlook for many consumer and service industries.

It can also cause currencies to shift relative to each other which often affects foreign investor appetitive, which may further depress some markets.

Plus, the turmoil causes some investors to panic and sell, further pushing down prices as they dump stocks.

So why haven't markets reacted sooner?

We've seen markets fall at times over the last couple of years due to concerns over debts, but nothing like this last week. The catalyst seems to have been a combination of warnings over eurozone debt levels, the US struggling to agree a debt package that would stave off default, weak economic data and (maybe) lower volumes of trades having a bigger impact on markets during holiday seasons.

Nevertheless, I still can't fathom why markets haven't reacted sooner (or, putting it another way, why they'd risen quite a lot over the last year). The underlying problems have been around for at least a couple of years and seem pretty obvious. Maybe markets have simply woken up to the harsh reality of what a mess many global economies are in?

I suppose we should factor in some companies doing extraordinarily well, thanks to cost cutting/efficiency/innovative products/commodity prices/luck, but this doesn't really explain the extent that markets had risen prior to last week.

Is it all doom and gloom?

In a worst case scenario lots of countries will go bust and in a best case scenario a combination of economic growth and austerity measures will help get everyone's finances back on track. In practice we'll probably see a few defaults and lots of struggles to balance the books, but most developed countries will likely get back to some sort of financial normality over the next 5-10 years.

What should you do?

It might be that stock markets have over-reacted and bounce back a bit next week, but I wouldn't be surprised if they remain volatile and generally in the doldrums for as long as the uncertainties over government debts and the possibility of defaults persist.

However, I'd avoid panic selling. While the outlook is hardly encouraging, I doubt this week's slide will continue with such severity, hopefully giving you time to re-assess your investments and ensure you're not taking excessive risk. The key thing is to ensure a sensible balance and avoid too much exposure to any one area unless you're comfortable with high volatility and happy to ride out the storm, however long it may last. For more details about investing through turbulent times see my article here.

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Readers' Comments (2) - To post a comment please register or login .

Comment by justin at 4:26pm on 08 Aug 2011:

Stock markets have fallen again today on the unexpected news that US government bonds have been downgraded from AAA to AA+ by ratings agency S&P. In itself this doeasn't mean that much, AA+ is still petrceived as very safe, but the simple fact the US has been downgraded is a negative signal that appears to have further worried investors, prompting more selling hence market falls.

Comment by mickz at 5:45pm on 15 Aug 2011:

"Nevertheless, I still can't fathom why markets haven't reacted sooner (or, putting it another way, why they'd risen quite a lot over the last year). The underlying problems have been around for at least a couple of years and seem pretty obvious."

I've been investing in the stock market over the last couple of years and so, in my own small way, have helped to push it higher. But the alternatives seem to be slowly losing the real value of cash due to unrealistically low interest rates, or risk losing a substantial chunk quickly if/when the property market drops.

So the stock market seems the least worst option, and if there are a few dips along the way then I can buy shares 10-20% cheaper than I could do a few weeks ago, which doesn't seem like a bad thing...