The US stock market has had its worst week in two years — should we be worried?

The US stock market has had its worst week in two years — should we be worried?

The US stock market has had its worst week in two years — should we be worried?

Updated 5 February 2018, 11:20 AEDT

With the mining boom now behind us, our major export market slowing and housing finance now past its peak, our economy and stock market remain vulnerable to any shift in global sentiment, writes Ian Verrender.

The numbers couldn't have been better. America's economy finally appeared to be out of the woods.

It was news that sparked a wave of selling on the New York Stock Exchange, sending Wall Street plunging on Friday night, capping its worst week in years with a 4.1 per cent decline in a move destined to rattle markets across the globe.

How to explain this apparent disconnect?

For a start, it's worth noting that until last week, the US stock market was a whopping 88 per cent higher than its pre-crash peak in 2007, and more than 300 per cent higher than the nadir it plumbed during the darkest hours of the financial crisis.

It was a stock market boom, the second longest in history, that transcended logic as investors drove the market to new records even as the US economy barely limped out of the crisis.

Except that it was entirely logical. For it was a boom created by central bankers; a radical experiment in monetary policy as the US, Europe and Japan sent interest rates to zero and, for the first time in recorded history, into negative territory, supplemented by printing vast amounts of new money.

A flood of money and interest-bearing securities delivering zilch: It was a recipe for a vast inflation in asset prices, from property to stocks and commodities.

That experiment has come to an end, at least in the US, and is rapidly being wound back in Europe.

Last week, Janet Yellen, in her last appearance as the head of the US Federal Reserve, hinted that the economy was improving enough to perhaps ratchet up the rate of interest rate hikes even as it reels in some of that extra cash.

On cue, employment numbers on Friday were better than anticipated. Not only that, wages finally appeared to be growing, indicating the long slumbering genie that is inflation has finally begun to stir.

It was enough to spook an already nervous Wall Street which for months has watched with concern as bond traders pushed market interest rates higher.

Suddenly, yields on relatively safe government securities are on a par, and in many cases superior, with those of much riskier stocks.

One way to look at it is that if a boom can be created out of thin air during the worst recession in a century, then it's entirely reasonable that stock markets could take a dive during good times.

Put another way, global stock markets have been artificially inflated for years by central banks. Guess what happens when the pump is removed?

The big question, however, is whether the Fed will allow the market to return to earth. Central banks globally, and particularly the Fed, have become prisoners of their own policies and now are captured by markets. Where once markets reacted to central banks, the opposite now is true.

The mere hint of a major correction will have them sweating bullets, fearful that a severe downturn will hit the real economy just as it is recovering.

Then there is the new Fed chairman, Jerome Powell.

He's a Trump appointee. And the President has made it clear that, in the absence of favourable polls, the stock market is the best indicator of his performance.

Investors have propelled Wall Street 50 per cent higher in the past two years, on the idea the Donald will pump up growth with his tax cuts and big spending plans.

Now, with those very policies likely to fuel inflation and debt, the pressure is on the Fed to lean hard against the Government.

If Powell is tempted to scale back the rate rises just to keep markets buoyed, longer term it would be disastrous for America and the rest of the world.

How will this affect us?

Unlike the US, the Australian market is still around 10 per cent below its 2007 peak. Partly that's because we never played the money printing game and until last week, our market interest rates were much higher than the US, and most other developed nations.

But that underperformance won't be enough to insulate us from a serious global market shake-out, should the Fed allow it to happen.

Our stock market is dominated by two things; financing housing purchases and digging up dirt. It's a neat reflection of our economy.

With the mining boom now behind us, our major export market slowing and housing finance now past its peak, our economy and our stock market remain vulnerable to any shift in global sentiment.

The good news — our interest rates are going nowhere

Unlike the US, Australian wages growth remains stuck in the slow lane and last week our inflation figures disappointed for the second quarter in succession.

For those still betting on an interest rate rise this year, it would be wise to look at the charts below.

Real estate prices nationally are on the wane and developers have suddenly taken notice, dramatically scaling back their plans to build new apartments, particularly in the most populous centres of Sydney and Melbourne. That will weigh on employment.

Interest only loans, which not long ago made up just shy of half the lending market, now have dropped to 16 per cent, well short of the mandated maximum 30 per cent from the banking regulator.

The housing construction boom, deliberately fuelled by Reserve Bank rate cuts from late 2012 on, was designed to boost employment in an economy weaning itself off a mining construction boom.

It was aided and abetted by federal government immigration policies that have contributed to a 400,000 annual population increase.

That's left our cities choked, hindered our productivity and necessitated a belated but insufficient infrastructure spend, which already appears to be past its peak.

In this environment, and with households struggling under a mountain of debt — now sitting at a staggering 199.7 per cent — the last thing the Reserve Bank would be considering is an interest rate hike.

Why do financial markets matter?

Once upon a time, most economists dismissed the idea that stock markets could affect real economic activity. It was all just speculation on the fringes, they argued. That's no longer the case.

The reason central banks, including our own, fear a market collapse is that when stock prices plunge, it feeds into a negative loop.

With most of us now heavily invested in markets through superannuation, a downturn will ripple through the economy. We feel poorer, so we spend less. That then hurts businesses.

As profits decline, businesses lay off workers.

For Australia, a nation obsessed with real estate, that phenomenon already is occurring.

While our Reserve Bank was happy to sit back and watch a generation of Australians being locked out of the housing market, since the frenzy provided a short-term sugar hit to economic growth, coping with the inevitable correction will be a challenge.

Most are hoping for a steady easing so hugely indebted homeowners don't end up under water.

You wouldn't want to be in Phil Lowe's shoes.