With the onset of the pandemic in early 2020, stock markets around the world fell dramatically, with many indices falling by 30% or more. In the USA, the Dow Jones fell by 37% and the Nasdaq fell by 30%. In the UK, the FTSE 100 fell by 33% and the FTSE 250 by 41%.
But with a combination of large-scale government support for their economies, quantitative easing by central banks and returning confidence of investors, stock markets then made a sustained recovery and have continued to grow strongly since – until recently, that is.
With inflation well above target levels, central banks have ended quantitative easing (QE) or have indicated that they soon will. Interest rates are set to rise, if only slowly. The Bank of England raised Bank Rate from its historic low of 0.1% to 0.25% in December 2021 and ceased QE, having reached its target of £895 billion of asset purchases. The Fed has announced that it will gradually raise interest rates and will end QE in March 2022, and later in the year could begin selling some of the assets it has purchased (quantitative tightening). The ECB is not ending QE or raising interest rates for the time being, but is likely to do so later in the year.
At the same time economic growth is slowing, leading to fears of stagflation. Governments are likely to dampen growth further by tightening fiscal policy. In the UK, national insurance is set to rise by 1.25 percentage points in April.
The slowdown in growth may discourage central banks from tightening monetary policy more than very slightly. Indeed, in the light of its slowing economy, the Chinese central bank cut interest rates on 20 January 2022. Nevertheless, it is likely that the global trend will be towards tighter monetary policy.
The fears of slowing growth and tighter monetary and fiscal policy have led many stock market investors to predict an end to the rise in stock market prices – an end to the ‘bull run’.
The key question is what will investors believe. If they believe that share prices have peaked they are likely to sell. This has happened since early January, especially in the USA and especially with stocks in the high-tech sector – such stocks being heavily represented in the Nasdaq composite, a broad-based index that includes over 2500 of the equities listed on the Nasdaq stock exchange. From 3 to 21 January the index fell from 15 833 to 13 769, a fall of 13%. But will this fall be seen as enough to reflect the current economic and financial climate. If so, it could fluctuate around this sort of level.
However, some may speculate that the fall has further to go – that indices are still too high to reflect the earning potential of companies – that the price–earnings ratio is still too high for most shares. If this is the majority view, share prices will indeed fall.
Others may feel that 13% is an overcorrection and that the economic climate is not as bleak as first thought and that the Omicron coronavirus variant, being relatively mild for most people, especially if ‘triple jabbed’, may do less economic damage than first feared. In this scenario, people are likely to buy shares while they are temporarily low.
But a lot of this is second-guessing what other people will do – known as a Keynesian beauty contest situation. If people believe others will buy, they will too and this will push share prices up. If they think others will sell, they will too and this will push share prices down. They will all desperately wish they had a crystal ball as they speculate how people will interpret what central banks, governments and other investors will do.
House prices are soaring throughout the world, making them unaffordable for many first-time buyers. In the UK, for example, according to the Nationwide, the annual house price increase was 13.4% in 2021 Q2. In the USA, house prices are rising by over 23% per annum.
The reason for this rampant house price inflation is that demand is rising much faster than supply. What is more, with inelastic supply in the short term, a given percentage rise in demand leads to a larger percentage increase in prices.
Reasons for rapidly rising house prices
But why has demand risen so rapidly? One major reason is that central banks have engaged in massive quantitative easing. This has driven down interest rates to historic lows and has led to huge asset purchases. Mortgage lenders, awash with money, have been able to increase the ratio of lending to income. Borrowing by house purchasers, encouraged by low interest rates and easy access to mortgages, has thus increased rapidly.
Another reason for the increased demand is that economies are beginning to recover from the COVID-induced recessions. This makes people more confident about their future financial positions and more willing to take on increased mortgage debt. Another reason is that, with increased working from home, people are looking for larger houses where rooms can be used as studies. Another is that, with less spending during the lockdowns, people have built up savings, which can be used to buy larger homes.
Some countries have deliberately boosted demand by fiscal measures. In the UK, the government introduced a stamp duty ‘holiday’. Previously a 3% ‘stamp duty’ tax was applied to purchases over £125 000. Under the holiday scheme, the rate would only apply to purchases over £500 000 until 30 June 2021 and then to purchases over £250 000 until 30 September 2021. This massively boosted demand, especially as the deadlines approached. In the USA, there are various schemes at federal and state level to support first-time buyers, including low-interest loans and vouchers. Supporting demand is counterproductive if it merely leads to higher prices and thus does not make it easier for people to buy.
Speculation has played a major part too, with many potential purchasers keen to buy before prices rise further. On the supply side, some vendors have held back hoping to get a higher price by waiting. Gazumping has returned. This is where vendors accept a new higher offer even though they have already accepted a previous lower one.
Effects of higher house prices
Higher house prices have had a knock-on effect on rents, which have also soared. This has encouraged house purchases for rent both by individuals and by property investment companies. The effect of rapidly rising house prices and rents has been to increase the divide in society between property owners and those unable to afford to buy and forced to rent.
Increased housing wealth is likely to lead to greater housing equity withdrawal. This is where people draw on some of their equity in order to finance increased consumer spending, thereby boosting aggregate demand and possibly inflation.
Will the house price boom end soon?
One scenario is that there will be a gradual slowdown in house price increases as quantitative easing is tapered off and as support measures, such as the UK’s stamp duty holiday, are unwound.
There is a real possibility, however, that there will be a more severe correction, with house prices actually falling. This could be triggered by central banks raising interest rates in response to higher inflation caused by the recovery and by higher commodity prices. In the UK, labour shortages brought about by Brexit could make the inflationary problem worse. With high levels of mortgage debt, even a half percentage point rise in mortgage interest rates could have a severe effect on demand. Falling house prices will then be compounded by speculation, with buyers holding off and sellers rushing to sell.
Speculation in markets can lead to wild swings in prices as exuberance drives up prices and
pessimism leads to price crashes. When the rise in price exceeds underlying fundamentals, such as profit, the result is a bubble. And bubbles burst.
There have been many examples of bubbles throughout history. One of the most famous is that of tulips in the 17th century. As Box 2.4 in Essential Economics for Business (6th edition) explains:
Between November 1636 and February 1637, there was a 20-fold increase in the price of tulip bulbs, such that a skilled worker’s annual salary would not even cover the price of one bulb. Some were even worth more than a luxury home! But, only three months later, their price had fallen by 99 per cent. Some traders refused to pay the high price and others began to sell their tulips. Prices began falling. This dampened demand (as tulips were seen to be a poor investment) and encouraged more people to sell their tulips. Soon the price was in freefall, with everyone selling. The bubble had burst .
Another example was the South Sea Bubble of 1720. Here, shares in the South Sea Company, given a monopoly by the British government to trade with South America, increased by 900% before collapsing through a lack of trade.
Another, more recent, example is that of Poseidon. This was an Australian nickel mining company which announced in September 1969 that it had discovered a large seam of nickel at Mount Windarra, WA. What followed was a bubble. The share price rose from $0.80 in mid-1969 to a peak of $280 in February 1970 and then crashed to just a few dollars.
Other examples are the Dotcom bubble of the 1990s, the US housing bubble of the mid-2000s and BitCoin, which has seen more than one bubble.
Bubbles always burst eventually. If you buy at a low price and sell at the peak, you can make a lot of money. But many will get their fingers burnt. Those who come late into the market may pay a high price and, if they are slow to sell, can then make a large loss.
GameStop shares – an unlikely candidate for a bubble
The most recent example of a bubble is GameStop. This is a chain of shops in the USA selling games, consoles and other electronic items. During the pandemic it has struggled, as games consumers have turned to online sellers of consoles and online games. It has been forced to close a number of stores. In July 2020, its share price was around $4. With the general recovery in stock markets, this drifted upwards to just under $20 by 12 January 2021.
Then the bubble began.
Hedge fund shorting
Believing that the GameStop shares were now overvalued and likely to fall, many hedge funds started shorting the shares. Shorting (or ‘short selling’) is where investors borrow shares for a fee and immediately sell them on at the current price, agreeing to return them to the lender on a specified day in the near future (the ‘expiration date’). But as the investors have sold the shares they borrowed, they must now buy them at the current price on or before the expiration date so they can return them to the lenders. If the price falls between the two dates, the investors will gain. For example, if you borrow shares and immediately sell them at a current price of £5 and then by the expiration date the price has fallen to $2 and you buy them back at that price to return them to the lender, you make a £3 profit.
But this is a risky strategy. If the price rises between the two dates, investors will lose – as events were to prove.
The swarm of small investors
Enter the ‘armchair investor’. During lockdown, small-scale amateur investing in shares has become a popular activity, with people seeking to make easy gains from the comfort of their own homes. This has been facilitated by online trading platforms such as Robinhood and Trading212. These are easy and cheap, or even free, to use.
What is more, many users of these sites were also collaborating on social media platforms, such as Reddit. They were encouraging each other to buy shares in GameStop and some other companies. In fact, many of these small investors were seeing it as a battle with large-scale institutional investors, such as hedge funds – a David vs. Goliath battle.
With swarms of small investors buying GameStop, its share price surged. From $20 on 12 January, it doubled in price within two days and had reached $77 by 25 January. The frenzy on Reddit then really gathered pace. The share price peaked at $468 early on 28 January. It then fell to $126 less than two hours later, only to rise again to $354 at the beginning of the next day.
Many large investors who had shorted GameStop shares made big losses. Analytics firm Ortex estimated that hedge funds lost a total of $12.5 billion in January. Many small investors, however, who bought early and sold at the peak made huge gains. Other small investors who got the timing wrong made large losses.
And it was not just GameStop. Social media were buzzing with suggestions about buying shares in other poorly performing companies that large-scale institutional investors were shorting. Another target was silver and silver mines. At one point, silver prices rose by more than 10% on 1 February. However, money invested in silver is huge relative to GameStop and hence small investors were unlikely to shift prices by anything like as much as GameStop shares.
Amidst this turmoil, the US Securities and Exchange Commission (SEC) issued a statement on 29 January. It warned that it was working closely with other regulators and the US stock exchange ‘to ensure that regulated entities uphold their obligations to protect investors and to identify and pursue potential wrongdoing’. It remains to be seen, however, what it can do to curb the concerted activities of small investors. Perhaps, only the experience of bubbles bursting and the severe losses that can result will make small investors think twice about backing failing companies. Some Davids may beat Goliath; others will be defeated.
Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.
When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.
The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).
But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?
In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).
But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.
Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).
But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.
A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.
If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.
There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.
Back in October, we examined the rise in oil prices. We said that, ‘With Brent crude currently at around $85 per barrel, some commentators are predicting the price could reach $100. At the beginning of the year, the price was $67 per barrel; in June last year it was $44. In January 2016, it reached a low of $26.’ In that blog we looked at the causes on both the demand and supply sides of the oil market. On the demand side, the world economy had been growing relatively strongly. On the supply side there had been increasing constraints, such as sanctions on Iran, the turmoil in Venezuela and the failure of shale oil output to expand as much as had been anticipated.
But what a difference a few weeks can make!
Brent crude prices have fallen from $86 per barrel in early October to just over $50 by the end of the year – a fall of 41 per cent. (Click here for a PowerPoint of the chart.) Explanations can again be found on both the demand and supply sides.
On the demand side, global growth is falling and there is concern about a possible recession (see the blog: Is the USA heading for recession?). The Bloomberg article below reports that all three main agencies concerned with the oil market – the U.S. Energy Information Administration, the Paris-based International Energy Agency and OPEC – have trimmed their oil demand growth forecasts for 2019. With lower expected demand, oil companies are beginning to run down stocks and thus require to purchase less crude oil.
On the supply side, US shale output has grown rapidly in recent weeks and US output has now reached a record level of 11.7 million barrels per day (mbpd), up from 10.0 mbpd in January 2018, 8.8 mbpd in January 2017 and 5.4 mbpd in January 2010. The USA is now the world’s biggest oil producer, with Russia producing around 11.4 mpbd and Saudi Arabia around 11.1 mpbd.
Total world supply by the end of 2018 of around 102 mbpd is some 2.5 mbpd higher than expected at the beginning of 2018 and around 0.5 mbpd greater than consumption at current prices (the remainder going into storage).
So will oil prices continue to fall? Most analysts expect them to rise somewhat in the near future. Markets may have overcorrected to the gloomy news about global growth. On the supply side, global oil production fell in December by 0.53 mbpd. In addition OPEC and Russia have signed an accord to reduce their joint production by 1.2 mbpd starting this month (January). What is more, US sanctions on Iran have continued to curb its oil exports.
But whatever happens to global growth and oil production, the future price will continue to reflect demand and supply. The difficulty for forecasters is in predicting just what the levels of demand and supply will be in these uncertain times.