/ Analysis

The Markets Explained - Part I

To read Part II about the Indian Markets, click here.

The last two weeks have seen global stock markets swing more wildly than we’re used to seeing them swing. All of this comes after a year of relative calm, where stock markets rose like a feather in the sea breeze.

The recent market corrections have ushered in a mood of panic, with many worrying that the downturn portends the beginning of a steep decline - an end to the happy bull story that we’ve run with for the last few years.

In my opinion, the panic is unwarranted.


To understand why the panic is unwarranted, let’s start with looking at what has caused this decline. To clear up a misconception, the decline is not because of the reintroduction of the Long Term Capital Gains tax! Even though Mr. Jaitley’s announcement did shock the Indian markets, and would have caused a market crash, the markets would have also quickly rebounded. Capital gains tax is still far lower than most other tax rates in the country, and is also lower than Capital gains taxation rates in other countries, and the stock market continues to remain an excellent place for individuals to invest for high returns.

The reasons for this decline go beyond our borders. The origins of the stock market crash lie in the US, and in one specific report. On the 2nd of February, the American Bureau of Labor Statistics came out with its Employment Situation Summary came out. Also called the Jobs Report, this document details the unemployment rate as well as the rate at which wages are increasing. The report said that wages grew at 2.9%, while unemployment dropped to 4.1%; these are signs that inflation is going to pick up in the American economy. The explanation for this is simple: the American economy is doing well, so businesses are trying to hire more people. However, since every company is trying to hire, competition to get employees to join a company has become intense. To successfully hire employees, businesses have to increase the salaries they pay. This is actually very good news as far as the economy is concerned.

However, there is a limit to how far we want this cycle to go. If wages keep increasing, and unemployment keeps decreasing, inflation goes up too (see the Phillips Curve for an explanation). The American Central Bank - the Federal Reserve, is in charge of keeping inflation under control. In case inflation is increasing too quickly, the Fed can attempt to keep it under control by increasing interest rates.

Increasing interest makes borrowing money more expensive and saving money more profitable, thus incentivizing people to spend less. This reduces economic growth, and keeps inflation under control.

Increasing interest rates cause the stock market to crash. Lower economic growth also means lower stock prices. Furthermore, with higher interest rates, investing in bonds is more desirable than investing in stocks, causing further stock price declines.

So in this case, the markets crashed because investors anticipate that the Fed will have to increase interest rates faster than anticipated in order to control inflation. It it is somewhat funny that a single number, that can only be estimated statistically, that too with a relatively high margin of error, caused all this panic in the American markets.

It is worth looking at this correction with some perspective too. The US markets have only crashed to their December levels. Furthermore, the degree correction is also due to an unwinding of a popular trade, going short on volatility.

Perhaps this correction is much needed. It’s a sign that the days of endlessly low interest rates are coming to an end. We’re finally coming back to the normality seen before the 2008 crisis recovery began. The economies of the developed world are in much better shape than they’ve been in years, and good news about the economy bodes well in the long run for any stock market. So if you’re in America, don’t worry too much.

How will this affect the Indian markets though? That’s a bit more complicated. Read our Part 2 post here for more.

For more reading:


To read Part II about the Indian Markets, click here.

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Pranshu Maheshwari

Pranshu Maheshwari

Finance and stat nerd, Wharton alum, used to have a great handlebar moustache. And I started SimpleMoney!

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