Questions and answers about the market's turmoil
By DANIEL WAGNER
Global stock markets tumbled Monday on the first trading day since Standard & Poor's downgraded long-term U.S. debt. The Dow Jones industrial average plunged 634.76 points, the sixth-worst point less in its 112-year history. Investors are anxious about a weakening U.S. economy and a widening debt crisis in Europe.
Some analysts had worried that Treasury yields would surge after S&P's downgrade. That would happen if investors demanded higher returns to compensate for their risk.
The opposite happened. Treasury yields fell Monday to their lowest level of the year as investors sought a safe place for their cash. Their actions showed continued confidence in long-term U.S. debt.
Here are some questions and answers about the market's turmoil Monday:
Q: Why are stock prices plunging?
A: Stocks are considered risky, especially when the economy falters. When the economy is growing, companies can expand, hire and increase profits. A string of bad economic data has led many investors to worry that the economy will dip back into recession. If that happens, stocks would likely slide further. Investors already were growing fearful about the economy before S&P's announcement Friday night. Oil prices also are falling, a sign that traders expect the weak economy to reduce demand from consumers and businesses.
Q: If everyone is selling stocks, where's that money going?
A: Anywhere safe. Traders are plowing cash into investments that are seen as hedges against economic weakness. Gold prices streaked past $1,700 for the first time Monday. And the yields on debt issued by the U.S. Treasury fell as traders, money managers and overseas banks sought refuge from the market's wild swings. Bond yields fall as their prices rise.
Q: Why are Treasury prices rising? Didn't S&P just indicate that they are a riskier investment?
A: Investors remain confident that the Treasury will be able to pay its creditors, downgrade or not. And Treasurys are still the world standard for safe, stable investments that can be converted into cash easily. Other nations with AAA ratings have much smaller economies and issue much less debt. When investors seek safety, they don't have many options other than Treasurys.
Q: If the S&P downgrade isn't driving all this selling, why are markets plunging now? After all, the economic data was relatively encouraging on Thursday, when the Dow had its worst one-day point drop since 2008.
A: Things are looking grim in Europe. Central bankers there are trying to prevent Italy and Spain from becoming the latest nations to default on their debts. The European Central Bank on Monday is buying up bonds issued by those countries, to increase demand for them. A default by Spain or Italy would be disastrous for other nations that use the euro and could affect financial companies worldwide.
Q: Are investors more optimistic about overseas stock markets?
A: Not at all. Stocks around the world have taken a pounding. Even developing markets are vulnerable because of how U.S. and European weakness could reverberate globally.
Q: Does this mean the economy is headed for another recession?
A: It can't be ruled out. Analysts note that the stock market's dive will make people feel less wealthy and discourage some from buying new cars and homes. If enough people feel discouraged by their loss of wealth and cut back on purchases, fears of another recession could become self-fulfilling.
The market reacts to U.S. credit downgrade
The Chase by Marty Cej:
"I think S&P has demonstrated some spine; they finally got it right."
- Bill Gross, PIMCO founder and manager of the world's biggest bond fund, to Bloomberg News.
"We don't care what S&P thinks, about Treasuries or anything else. And we are completely baffled that anyone else would take it remotely seriously, either."
- Ian Shepherdson, chief U.S. economist at High Frequency Economics.
So many angles, so little time. Our immediate focus must be on the markets: bonds, currencies, stocks and commodities. The bond market will dictate the direction of stocks today as investors try to price in the impact of higher borrowing costs in the U.S. on economic growth and earnings. Most of our viewers view the health of the financial system through the prism of their own stock portfolios so we need to constantly connect the dots and answer the questions of how and why a downgrade to U.S. debt affects Canadian equities.
In the simplest terms, higher interest rates on U.S. bonds mean higher rates on any loans tied to Treasury securities, such as mortgages and car loans. Higher borrowing costs for U.S. consumers and companies mean slower growth, which in turn means less demand for goods and services. But will this downgrade from S&P necessarily lead to higher rates? In a note to clients this weekend, the analysts at Strategas examined all the instances of downgrades from AAA over the past 25 years and found that in 10 of 11 cases, the local 10-year government bond yield was lower a year later. Governments, they argue, fight back when they are challenged. Barry Ritholtz has pointed out as well that Japanese stocks rallied more than 3 percent on the first day of trading after that country's debt was downgraded in 2001.
We need to pick apart the impact of the debt downgrade on stock sectors including the financials, resources, consumer discretionary and technology. Did I mention the financials? That includes the banks, insurers and money managers.
Glancing away from the stock market for a moment, we'll need to talk about what it means for the Canadian bond market now that we are one of the few AAA credit ratings left out there that can still field a competitive hockey team. A quick look at the screens shows the yield on the 10-year Canadian bond soaring 14 basis points to 2.63 percent. What gives? Just as the downgrade to U.S. debt will have knock-on implications for state and municipal debt as well as the debt on U.S. government-related entities, there will be knock-on affects for Canadian provincial, municipal and corporate debt.
And what about the ratings agencies themselves? Here's what PIMCO's Mohamed El-Erian had to say: "The future role of rating agencies will also now come under close scrutiny, bringing to the fore the question of who rates the rating agencies? S&P's action will likely unite governments in America and Europe in an effort to erode their monopoly power and operational influence. This will also force all investors to do something that they should have been doing for years: conduct their own ratings due diligence, rather than rely on outsiders." Has S&P bolstered its reputation or ruined it for good?
The G-7 said it will step in with a coordinate effort to stabilize financial markets with particular attention to the currency market and the ECB has stepped in to buy Italian and Spanish bonds – yields on 10-year debt are down 75 and 83 basis points respectively – so could today actually prove to be the inflection point in the rout that has lasted two weeks?
In commodities, gold is shining and oil is tumbling. Pork bellies – bacon, mmmmmm – wheat, sugar, copper… they're all down.
That's just for starters, and I haven't even touched on Europe.
Posts
