Remembering ’87, bonds in play again

Some anniversaries should not be celebrated, and that’s certainly the case with the 36th anniversary of the 1987 stock market crash later this month.

What’s particularly concerning is the state of global financial conditions, which some claim point to a possible repeat of that traumatic event.

The 1987 crash started on Monday October 19 in New York. It was a big deal for US investors, but as the seismic waves from a 23 per cent fall in the Dow Jones index spread globally it became a bigger event in Australia, where the stock market lost 25 per cent the following day.

Western Australia, with an economy dominated back then by a group of heavily indebted entrepreneurs such as Robert Holmes à Court, Laurie Connell and Alan Bond, was totally exposed to the effects of the crash, which also destablised the state government led by Brian Burke.

The close connections between business and government created a toxic mix that took years to resolve, as well as severely bruising WA’s reputation.

The 1980s, which had begun with a bang in Perth ended with a whimper, so if there is going to be a repeat it’s worth asking whether the effects of a stock market crash would be identical.

The short answer to that question is ‘no’.

This time it will be different, though that doesn’t mean it will be less painful because WA is the most trade-exposed of the Australian states, heavily dependent on exports of raw materials such as iron ore, gas, lithium and alumina.

The damage could be substantial if demand for those commodities shrinks and prices fall; we just don’t know exactly where it will be felt or who among the current crop of business leaders is exposed through excess debt or hidden losses.

The pain of a crash, which will dry up bank lending and hurt stock market investors, will also flow into property values, which are currently elevated because of a housing shortage and rising post-COVID immigration.

Hints of a stock market correction have been evident for much of the past two years and can be directly connected to the change in interest rates settings that have turned from ultra-low during COVID to much higher today, and possibly even higher by the end of the year.

At its simplest, what’s happening is that investors have finally spotted the obvious flaw in stock market investing and its associated risks, compared with the safer option of leaving cash in the bank or owning government bonds.

It’s the current flow of money out of the stock market into bonds that has sparked comparisons with events in October 1987 and can be seen in sharply lower bond prices as interest rates rise.

Albert Edwards, a seasoned British economist at the French bank Société Générale, stirred the theory of a 1987 repeat earlier this month when he said the fact the stock market had not fallen steeply amid rising bond yields bore the hallmarks of that crash.

Known for his permanently pessimistic view of financial markets, Mr Edwards has the credentials to make the comparison because he was working at the Bank of England in 1987.

“The stock market’s current resilience in the face of rising bond yields reminds me very much of events in ’87, when equity investors’ bullishness was eventually squashed,” Mr Edwards said.

The key point is probably lost on most Australian investors, who have limited knowledge of the bond market even though it is the place where long-term asset values are determined.

When a major change occurs in the bond market, such as that happening now, massive losses can be incurred by institutions such as banks and insurance companies, which buy bonds because they are regarded as a safe investment. Commercial property developers can also be heavily exposed.

Bonds bought in early 2020 when yields on the 10-year note were close to 0.5 per cent are now trading at a fraction of the price because a recently issued note yields close to 5 per cent, which means some investors are wearing huge losses that must eventually be recognised (potentially wiping out the holder).

Bill Gross, co-founder of the big US investor Pacific Investment Management Company (Pimco), is in no doubt that there’s trouble ahead.

Stocks are clearly overvalued, Mr Gross said while also pointing to the connection between bond yields and share prices.

What’s delayed a reaction to the high (and rising) interest rates on bonds is the latest investment fad: artificial intelligence (AI).

“The excitement about the potential of AI breakthroughs and rampant government spending have blunted the impact [of high bond yields],” Mr Gross said.

Another sign of trouble ahead is increasing investment in the Volatility Index (Vix) of the Chicago Board of Options Exchange. The Vix is a theoretical measure of future volatility in the US stock market, providing a form of insurance in a stock market crash.

And then there’s the problem with October, a time that makes US investors nervous after crashes in that month in 1907, 1929 and 1987, with another repeat possible.

Some thanks

FOR those unsure about how quickly markets can flip from positive to negative, consider the case of COVID vaccine makers, which invented lifesaving medicines only to be hammered by investors because the vaccines worked better than anyone expected.

Shares in BioNTech – which played a leading role in the development of the revolutionary mRNA vaccine that just earned its inventors a Nobel Prize – has crashed by 72 per cent in two years.

Moderna, another vaccine maker, is down 79 per cent, while the prize for hardest hit goes to Novavax, which was too late to the market and has suffered a 97 per cent share price fall in two years.

Pfizer, arguably the winner because it has sold more vaccines than the other makers combined, is down 46 per cent.

Hot property

IT’S a different story with Ferrari, which makes its money by limiting production of its cars, thereby encouraging competition among buyers to create a sense of exclusivity.

While other carmakers churn out vehicles in the millions, Ferrari only makes about 8,500 a year and has a three-year waiting list of new possible buyers (but only if each buyer meets Ferrari’s standards).

The net result is a share price up 40 per cent this year and up 180 per cent over the past five years.