The falling stock market, for dummies!

So, global equity markets have taken a nose dive. A year of impressive gains for the FTSE 100 were reversed in a week. This has been caused by recent data suggesting strength in the global economy, seems bizarre, right? In this longer than usual piece we take it right down to the basics to explain the concepts like inflation and interest in a really simple and understandable way. Even with no knowledge of economics, we hope that by the end of the piece you will understand the seemingly paradoxical relationship behind the recent market sell off. (Warning: disgraceful use of the classic Freddo example within!)

Firstly, we need to understand deflation and inflation. Both of which are a symptom of the relationship between money and the products it is used to buy, in other words, supply and demand. The classic example of this is a Freddo. We know 25p price tag sends shivers down your spine as you crave the days when MSN messenger was still a thing and the chocolate frog was yours for a mere 5p. There are many potentially complicated factors involved in this price rise but simply, its inflation. This is where the demand for Freddos has increased more than their supply. Imagine you have a Freddo to sell and one person is waiving a 5p in front of your face, compare this to 10 people vying to taste your amphibian friend. In the latter scenario you would probably end up getting more than 5p for it assuming you’re not a lemon, right? It now takes more pennies to buy the chocolate treat because there is more cash chasing after the same product. So, this has had the effect of devaluing the currency. Imagine you have £100 under your bed in year 1 and the annual inflation rate for Great British pounds is 1%. If in year 2 you took that £100 to the shops, what you could buy with it now, would be the same as what you could have bought for £99 in year 1. Each pound is now worth 1% less, thanks to inflation. Since population is ever-increasing, demand for products rises with it, this explains why inflation ultimately rises in the long run.

Gross Domestic Product (GDP) is the measured value of the goods that a country is producing, so it is affected by price and quantity. The rise in GDP during prosperous times can be explained by lower unemployment and higher wages. There are more people who can afford to buy Freddos so their demand is greater, this will cause their price to increase due to inflation. Therefore, when a country is prospering through a growing GDP, inflation rises. Since money is devaluing, each pound you are being paid is worth less. It is important that people’s pay is increasing accordingly to compensate this. If inflation rises too rapidly, this is difficult to achieve. It is also difficult to plan for the future and in extreme cases it can lead to hyperinflation, where a currency devalues uncontrollably. Although this can be caused by reasons other than economic prosperity. You may have heard horror stories of post war Germany where after excessive money printing, wheel barrows of cash were needed to buy a loaf of bread as each note was worth so little.

Deflation, you guessed it, is the opposite of inflation, and so is caused by supply outstripping demand. It is in fact inflations evil brother and no one likes him. You might think “wait, if deflation is the opposite of inflation then my Freddo would get cheaper each year, right? Sounds great!”. Unfortunately, deflation usually accompanies economic recession so gorging on cheap Freddos may be the only way to pass the day when you’re unemployed. In bad times, people have no money and so cannot afford to splash out on stuff, meaning the demand for goods is lowered. Money is becoming scarcer than Freddos. No one can afford to buy the chocolate so you have sell it on the cheap. Money is becoming more valuable as you can get more for each penny. This is deflation and as you can see it’s not fun for most of us because we would likely be strapped for cash. It is important therefore to avoid deflation and to keep inflation at manageable levels, 2-3% annual inflation is generally deemed to be the sweet spot that policy makers aim for.

Inflation and interest rates have a close and inverse relationship. They’re like a married couple who consistently hold each other back. An interest rate is the amount you pay to borrow money to give the lender an incentive to lend to you. If you borrow £100 for a year at 5% annual interest, after the year is up you have to pay £105 back, so you’ve paid £5 or 5% to borrow that £100 for a year. Low interest rates mean that it is cheap to borrow money, referred to as “cheap money”. Since bank account savings rates are an interest rate, it also means that saving money is difficult. That measly 0.1% annual interest on your savings account sucks, right? So, this has the effect of encouraging people and companies to borrow money and go on a spending spree. People are spending and purchasing more products which increases the demand for these products. In response companies expand and employ more people to take advantage of this. More jobs, more money, more consuming, more demand, more jobs… you get the picture. As discussed previously, when consumer demand is high, this causes inflation. So low interest rates encourage high inflation. High interest rates on the other head reduce inflation. With high interest you have to pay more to borrow money and you would get decent returns leaving your money in a savings account. So, this encourages people and companies, to not borrow, not spend and to save instead. This means that people are spending and consuming less, meaning demand is lower. This lower demand for goods, means inflation is lower. So, interest rates can and are used by central banks to control inflation. Remember inflation is a symptom of the underlying supply and demand relationship. By keeping inflation at 2-3% central banks are effectively maintaining a low level of increasing demand for goods which they reckon is healthy for economic growth and stability.

After that impressive rant about Freddos I will now make it relevant to the current stocks sell off… eventually.

During the global economy’s almighty collapse in 2009, people suddenly had less money. This sent consumer spending sliding and therefore product demand too, leading to falling inflation and GDP. In order to halt this, central banks sought to lower interest rates. They rolled out a program of quantitative easing (QE) which involved buying up assets, predominantly government bonds. This is a bit more complicated so bear with me. A bond is effectively a loan, for example a bond may cost £100 and yield £10 after it expires in a year. This means you buy the bond for £100 and after the year is up you get this back as well as the £10 yield, so that’s a 10% return on your investment. Or in other words you’ve effectively received 10% interest on a loan that you have issued to borrower. However, the price of a bond can change, although the yield on a particular bond is fixed from its issuing. So, if the price of this bond increases to £200 due to demand, once the year is up you will receive a £10 return on your £200 investment, which is only a 5% return. Quantitative easing involves the purchasing of government bonds which increases their demand and therefore as discussed increases the bond’s price and lowers its interest rate. Now that interest rates on bonds, a form of borrowing, are reducing, this transfers to other forms of borrowing. Entities looking to borrow money can now demand lower interest rates as low interest government bonds are an option for them. So, it sets the tone for cheaper borrowing across the financial markets, in other words it lowers interest rates. There is another motivation for QE. During a financial crash, banks cut back on lending. Cash, which is essential for business function, can become scarce. Injecting some of the green stuff into financial markets by buying bonds helps to ease this.

Central banks also have a more direct control over interest rates. They can set the rate at which banks lend to one another, this is referred to as the “overnight rate”. Since a bank’s activity is affected by the rate it pays or receives from other banks, this rate trickles down to their customers through mortgage, credit cards etc. If the overnight rate decreases, it’s likely the rate of your credit card interest will follow suit if it is one that is variable. Therefore, this is another tool central bank uses to lower interest rates.

The problem is that quantitative easing was supposed to be a short term measure to keep markets afloat until GDP and inflation recovered naturally. However, it has been going on for a decade now. All the while companies have benefited from “cheap money” which is great for growing a business. Borrowing money to invest now and hardly paying any interest for it in the future allows a company to take advantage of opportunities to expand. Furthermore, as discussed a decade of low interest rates will have provided more consumer demand for these company’s goods, which translate to more revenue. A share price is a reflection of a company’s current value and prospective future value. If investor think a company is worth more, or will be worth more they buy the share which increases its demand and so the price goes up. The factors mentioned will have helped the company’s performance through higher sales and the ability to pursue expansion opportunities, this therefore will have been reflected in their share prices (I told you I would get there eventually).

The latest economic data released has pointed to an economy growing stronger. Record low US unemployment rates and impressive GDP growth from the eurozone are contributing to rising inflation. It is believed inflation could rise beyond the sacred 3% next year. Central banks may decide they no longer need to prop it up with quantitative easing and low interest rates. Furthermore, central banks may start to hike interest rates more aggressively to supress inflation. This is what it boils down to. Investors are concerned that the markets will suffer once interest rates start cranking up and quantitative easing winds down. As discussed, companies and consumers will be charged more to borrow and have less incentive to spend. This would have the desired effect of tackling inflation, but at a cost. It could hurt businesses as demand for their product falls and they can no longer invest as heavily in their growth. It’s understandable that as future sales and company expansion look a little bleaker that the share price takes a hit. Those selling off their stocks are betting that as a decade of hand holding and “cheap money” ends, markets may not stand on their own two feet.

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