Morning Brief – Warning or Inevitability?

Warning or Inevitability?

Yesterday almost every financial news channel out there was covering the Nasdaq Composite stock index. They were sharing headlines that versus its all-time high reached in November, the index had fallen 10%. 10%, but more commonly 20 and 25% after that, are seen as significant retracements in markets that could signal a price correction is underway. So after a big fall early on in yesterday’s trading session, the Nasdaq was entering into correction territory where the change in price level cannot be written off as mere market volatility and general price action. With all this attention surrounding one index – should you care?

Well if you own financial products linked to the performance of the Nasdaq or the primarily tech-related stocks it comprises of then yes, obviously. But let’s assume you’re an FX purist – does yesterday’s drop in one major US index have the cross-asset implications many articles theorised of yesterday?

Equity (stock) markets in general, face pressure from rising interest rates and when the theme of monetary tightening is pervading globally. As interest rates rise, bonds and cash provide stiffer competition to the returns of company stock altering the combined decision of investors to buy equities. Demand and therefore prices of equities and whole indices can consequently be under threat as monetary tightening unfolds. The Nasdaq, with a high composition of technology stocks, is hit the hardest due to the high growth assumptions investors price into the underlying earnings multiples of companies from this particular sector that ultimately influence equity prices.

The higher the growth assumption, the harder the fall when monetary tightening enters the equation. These high growth assumptions are in turn reliant upon plentiful liquidity and capital to finance innovation which in turn is directly constrained by tighter borrowing costs.

So, to answer the question, provided that the equity market sell-off remains largely isolated within stocks with high growth and earnings assumptions this can be read as an equity market rebalancing. It will only be the composition of equity valuations that changes without impacting wider risk conditions. In isolation yesterday’s sell-off in the Nasdaq index should not create meaningful distortions in other markets like foreign exchange. However, a broader correction that spills over into all stocks with a general decline in capitalisations could have greater impacts in the currency markets. Yesterday’s headlines are for now reporting an inevitability. Any more widespread decline could be well read as a warning.

Discussion and Analysis by Charles Porter

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