Equity markets: how far down it could go

Equity markets: how far down it could go
Written by insideindyhomes


Status: 06/15/2022 10:18 a.m

Difficult times for shareholders: the DAX has lost more than six percent in the past three trading days. Are more losses to be expected? And what can investors do in the crisis?

By Detlev Landmesser,

In the course of the year so far, the stock markets had coped relatively well with the expectation of rising interest rates. Especially when you consider that they also had to deal with the shock of the Russian attack on Ukraine. That has changed since last Friday. A wave of unrest swept global stock markets following the latest US inflation data. At 8.6 percent, inflation in May was well above expectations and reached its highest level in 40 years.

The DAX has lost 6.3 percent in value over the past three trading days. The market-wide US stock index S&P 500 is down more than 20 percent compared to its record close on Jan. 3, putting it in what is commonly defined as a “bear market”.

The US Federal Reserve will undoubtedly react to the continued unchecked inflation. Most market participants are now expecting a drastic rate hike of 0.75 percentage points from today’s monetary policy meeting.

However, sharply rising interest rates are generally poison for the stock markets because they make stocks less attractive in two ways. On the one hand, interest-bearing investments are becoming comparatively more attractive. On the other hand, it is becoming more expensive for companies to refinance themselves. This is the reason why high-growth technology companies, which are dependent on outside capital, react particularly sensitively to changes in interest rates.

Investors distrust monetary policy

The dynamics of macroeconomic processes such as the economy and inflation are difficult to control. And as is so often the case, investors doubt the ability of monetary policymakers around the world to rein in rampant inflation without damaging the economy.

In addition, interest rate hikes do little to combat inflation if the price increases are caused by external factors such as the Ukraine war. Energy or food shortages cannot be solved by raising interest rates.

More losses are imminent

Uncertainty and distrust are therefore high. Do investors have to be prepared for further price losses? Carolin Schulze Palstring, Head of Capital Market Analysis in Private Banking at Bankhaus Metzler, points to the unusual accumulation of imponderables. Further price declines cannot therefore be ruled out. In addition to interest rate fears and the burden of the Ukraine war, there is also concern that China will impose recurring lockdowns, which will exacerbate economic concerns.

A look at history offers no certainty, but at least a rough orientation: “Historically, corrections in the USA ended at around 20 percent on average if there was no recession – i.e. around the level that has now been reached,” explains the capital market expert. “In the case of a recession, the corrections usually went up to 30 percent.” However, if the crisis escalated into a genuine systemic crisis, i.e. a financial and debt crisis, corrections of up to 50 percent could also be observed.

“If there is a recession, there is still room for improvement. However, we do not currently expect a real systemic crisis,” says Schulze Palstring.

“Still some height to fall”

In order to sound out the ground for corrections in serious crises, the Metzler experts also consider the ratio of market and book value. This book value, which formed a reliable lower limit in previous phases of severe market turmoil, is currently around 9400 points in the DAX. “If push came to shove, there would still be quite a bit of fall,” says Schulze Palstring. However, this can only be assumed in an extreme situation.

However, it should also be noted that there has already been a significant adjustment in value on the stock markets in view of the changed interest rate and economic expectations.

Is gold a good hedge against inflation?

So what should private investors do in this situation? Even if so-called nominal assets such as bank deposits are traditionally popular in Germany – in times of increased inflation, Schulze Palstring pleads for the courage to have more substantial assets such as shares. “History shows that stocks can deal with inflation relatively well,” says the Metzler expert. In line with the expected interest rate hikes, the focus should not be on highly valued technology stocks. And in view of the rather negative economic expectations, investors should prefer defensive stocks to cyclical, i.e. economically sensitive stocks.

The expert is rather skeptical about gold, which is traditionally used as a protection against inflation: “Gold has not worked well as a protection against inflation of late. This is partly due to the strong US dollar, but above all because bonds are paying interest again and have therefore become an alternative. ” With bonds, on the other hand, it is important to focus on short maturities in view of the interest rate outlook.

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