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3 Potentially Troubling Developments for Wall Street

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Autumn is usually a turbulent season for Wall Street. Some major crashes have happened in autumn, including a 10% correction last September, and the 1929 and 1987 crashes in October.

The corrections or crashes began from record market highs, which stretched valuations for listed shares and record debt levels.

“Standard equity valuations are in the top 1% seen in the last 150 years, and there has also been a surge in M&A activity in recent quarters involving highly leveraged deals,” says Oxford Economics in a recent research briefing. “Corporate debt in the advanced economies has soared since early 2020, and U.S. high-yield debt issuance is at record levels.”

All these factors make some investors and market analysts nervous, as this year’s autumn season is underway, and significant equity indexes hover near all-time highs.

What could cause such a correction? Oxford Economics has identified two factors: a growth scare, and a spike in bond yields.

“Concerns have risen about financial market risks, centering around elevated asset valuations and high corporate debt. A lack of corporate distress and low-interest rates suggest no cause for panic. But a growth scare or a rise in bond yields – perhaps due to higher inflation – could change the picture.”

There’s also a third factor: stagflation.

A Growth Scare

By “growth scare,” economic analysts usually mean an unexpected slowdown in economic growth (“growth recession”), or an outright recession. Either scenario is bad for the equity and high-yield debt markets.

For equity markets, slow economic growth — or even negative growth — could be a big drag to the top and the bottom lines of listed companies, re-setting market valuations.

For high-yield corporate debt markets, a growth scare could fuel a wave of corporate defaults, sending investors in this asset class for cover.

Compounding the problem is the interdependence between equity markets and high-yield corporate debt markets, which could magnify market sell-offs.

Still, Oxford Economics thinks that these risks are overstated. For instance, valuations aren’t as stretched as they look, given the low-interest-rate environment.

“If we take low-interest rates into account, valuations for equities, commercial property, and high-yield bonds – while still mostly rich – look less extreme than they first appear. M&A flows as a share of world GDP, while high too, are below previous cyclical peaks.”

That’s a comforting thought, but there’s still the prospect of a spike in bond yields.

A Spike in Bond Yields

Treasury bond yields have stayed low for a long time, driving down the yields of all other types of bonds, and providing a cushion for equities. They are seen as the default choice for investors hunting for better returns for their money away from bonds, and money market funds.

Some market experts give credit for the low bond yields to central bankers and their ultra-accommodative policies. Others search for answers in the “savings conundrum” (e.g., Alan Greenspan), and the fiscal austerity in some areas of the world (e.g., the eurozone).

Then there’s low inflation, and in some countries — like Japan — deflation, which has depressed market expectations of future inflation, and kept long-term interest rates low.

The pandemic changed some of these parameters, however. For instance, it gave governments a free hand to spend and regulate labor markets, which accommodated the spike of inflation in the face of supply chain disruptions.

Central bankers have been quick to discount the resurgence of inflation, calling it a temporary phenomenon. What if they are wrong? Long-term interest rates could spike, as investors will demand an inflation premium to lend money out. That’s a terrible development for all classes of assets, including Treasury bonds.

Still, there’s something worse than that: stagflation.

Stagflation

Stagflation is the combination of economic stagnation, and rising inflation. The leading cause behind it is increasing production costs, and accommodative monetary and fiscal policies.

There are signs that the U.S. economy may be moving in that direction at this point.

Stagflation isn’t a good thing for any class of assets. Economic stagnation is bad for equities. It undermines corporate sales and profitability as spending stagnates, especially in the cyclical sectors.

Economic stagnation is also bad for high-debt yield sectors. It’s usually followed by a wave of corporate defaults, causing significant losses to the holders of high-yield corporate bonds.

Meanwhile, inflation causes a spike in bond yields, which is terrible for every asset class, including money market funds. Again, there is no place to hide.

Summary and Conclusions

Investors concerned about a significant market correction, or an outright crash, this autumn should keep a close eye on economic growth, inflation, or a combination of the two.

They have unsettled markets in the past, and they could do it again this time around, if they materialize.

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