What is wrong with the markets?

There is a simple and possible reason for the fall of the markets in the last few months. Sovereign wealth funds started to sell their previously purchased assets. By this, they overthrew the regular equilibrium and started a new, self-strengthening process.

In the last few years raw material orientated countries have used their profits from oil production through different channels (primarily sovereign wealth funds, but there were other ways as well), to purchase stocks, bonds and real estate. However with oil price drop this resource has dried up, moreover funds have to sell their previously purchased assets. If really this is the reason (one of them) for the fall on the markets, it’s logical that the price (rate) decrease first appeared on the corporate bond market; but which was already illiquid, also due to the regulations. This pushed up the premiums on bonds and at the same time it helped to grow the severity on bank credits.

research.stlouisfed.org
research.stlouisfed.org

If we accept this theory, than it coincides with the reality; on the illiquid corporate bond market, the sale of small amounts can generate big price drops. Meanwhile stock sell can be absorbed easily by the very liquid market, not least because of the huge repurchase of own shares. (It really happened, in 2015 the corporate bond market was very weak, but stocks were held together).

Now comes the positive feedback: because of the increased financing costs (due to bond sales), the borrowing became much more difficult and expensive for each company. Because of this the pace of share repurchases decreases, namely, spending power disappears to some degree on the stock market. Starting from this, sale of sovereign wealth funds could generate higher decreases. Further on, as a result of decrease in the stock and bond prices, financing becomes more expensive, stock repurchase is less and less, and stock prices are falling, which wakes uncertainty, which raises the risk premium of stocks and so on.

All in all, oil price decrease can cause easily, through sovereign wealth funds; stock market falls, without having real economic reason for it. For consumers cheaper fuel is an extremely big saving. This can help the economic development, which could last, even in the case of a fall down in the economy of emerging markets. In this way will evolve the “stick together” (by the way, in the same manner, as in 1998, summer-fall period), in which the real economy will grow, but on the stock market, chaos may appear.

Original date of Hungarian publication: February 3, 2016