Market correction coming: orderly, or carnage?

A market correction is coming. Will it be orderly?

The size and breadth of President Joe Biden’s planned stimulative initiatives create dangers that have been rarely encountered in world history.

Accordingly, there is no road map so forecasting is dangerous, but Amundi’s Christine Todd and I took a step back from the 10 major US actions that we set out on Thursday and came to some conclusions.

There will be a dramatic rise in US economic activity, which will benefit many enterprises, but almost certainly there will be a rise in inflation and that will cause US bond market interest rates to rise further as bond prices fall.

The sharemarket is harder to predict, but higher bond interest rates almost always reduce shares prices. The extra business activity will clearly be an offsetting factor.

In most cases, when there is a rise in US bond interest rates, that thrust extends to Australia and influences the cost of corporate borrowing. If the bond market rate rise becomes too severe, it will force the hand of the central bank in setting Australian rates.

If you didn’t catch Thursday’s 10 Biden thrusts, you can access them via our website under the heading “10 keys to the Biden economy”.

Christine Todd is the Boston-based US fixed-income head for Amundi, Europe’s largest investment manager, and brings to the table the trends that the US bond market is signalling.

The combination of the Trump money printing, the Biden money printing, the US shortage of skilled labour, the proposed doubling of the US minimum wage in many areas, a vaccination boost, a lower dollar and the problems in US supply chains provide a cocktail that could easily spin out of control.

The bond market is clearly very nervous but is constantly reassured by the US Federal Reserve and almost every US economist that inflation will not break out and interest rates will stay low for the foreseeable ­future. But the US bond market is not so sure.

At the start of the year the US 10-year bond rate was around 1 per cent and by August it had fallen to almost 0.5 per cent, triggering massive profits for bond holders. Then the market had second thoughts and it started to rise and it’s now back to around 1.1 per cent, causing big losses to those who purchased mid-year. Those who held their bonds right through the saga are approximately breaking even, but that conceals the fluctuations.

Todd thinks that even if inflation breaks out later in the year there will be a clamp on the rise in the bond yield because many overseas investors will want a slice of the US action if the 10-year bond rate hits 1.5 per cent.

In the sharemarket and to some extent in the bond market, the combination of so many initiatives will take an extended time to change current trends. In the case of the sharemarket, bullish trends once established can often run very strongly for extended periods and indeed the last leg of a bull market, like this one, can often be the most spectacular and go for long periods.

What I have described above heralds an orderly correction later in the year.

Wildcards to watch

Now let me canvass two theoretical events that could make the eventual correction become more severe.

There is an old stockmarket axiom that I was told in the late 1950s when it was politically acceptable. When the “tea lady” (read someone who knows nothing about the market) begins buying shares, it’s time to sell.

In the US, the modern equivalent of the long-departed “tea lady” is the vast number of people with minimal market knowledge who are borrowing money via Robinhood and others to buy shares.

We saw a whiff of the power of that force in the GameStop affair where the shares were driven to $US300 to smash shorters. But the Wall Street shorters eventually won and the shares are down to about $US50, causing some ­serious small shareholder losses.

If the market starts an orderly correction, that could easily trigger a mass exodus of inexperienced and highly leveraged investors.

I have seen many crashes where retail sellers flood the market, but given the accelerating money mobilisation via social media that is fanning this boom, there is potential for carnage.

The second wildcard is that the US, and many other countries, are planning large investments in carbon reduction and power storage. Using current technology, the building of renewable generator plant, batteries and other emission reduction equipment is going to require massive amounts of carbon-emitting materials such as steel, cement coal, oil and gas.

Normally the increase in demand would trigger large boosts to supply, but the carbon reduction investment demand is medium term. Longer term there will be a big decline in traditional materials using current production methods. This will curb production increases to meet ­demand.

At the same time, US and Australian banks and institutions are right now being told not to invest in carbon energy projects.

There is at least a possibility that we therefore could see an explosion in the price of resources which would further fan inflation around the world, increase the value of the Australian dollar and lift mining shares.

The recent rise in mining shares and the Australian dollar is an indicator that the market thinks something is afoot. Another marker to watch on this front is shares in the world’s largest coal miner, Peabody, which have been rising strongly despite the anti-carbon forces of Biden.

This last speculative twist in the tale raises the possibility that Australian bond and sharemarkets may perform better than other parts of the world.