Why the stock markets around the world plunged? – Explained

When America sneezes, the world catches a cold.

Earlier this week, in America, the Dow Jones Industrial Average witnessed two successive one-day falls– one for 666 points and the other for 1175 points. It was the largest one-day fall in its history. In percentage terms, the decline was 4.6 %.

It created ripples across global markets.

The stock markets in Europe and emerging nations also declined. The BSE Sensex fell more than 1200 points on the same day.

(Read: How is BSE Sensex Calculated?)

So, the question is why did Dow Jones fall?

1. Higher inflationary expectations in the future: The immediate reason for the decline was the release of employment and price data in the US. The data showed an increase in wage inflation to 2.9 %. Increase in wages might give a boost to inflation of general prices in the economy. Also, the US Government had announced massive income tax and corporate tax (worth $1.5 trillion) cuts last month. The tax cuts will lead to a higher fiscal deficit and drive inflation. [Increase in inflation means that investors will have to discount future cash flows at higher interest rates. In other words, gain of Rs. 100 after one year will be less important because general prices/ inflation will also increase. Hence, there was a spike in selling in the stock market and the share prices plunged.]
2. Increase in bond yields: The bond yields or returns started increasing last month in the US. Usually, bond yield and share prices are inversely related. One of the reasons is that the future equity cash flows are discounted at a higher rate. (bond yield is one of the components of the discount rate along with inflation)
3. Expectations of an increase in interest rates: There was also a concern that the Federal Reserve could increase interest rates in response to inflationary pressures in the economy. The US federal reserve indicated that it might hike policy rates more than 3 times this year. It means that the period of low-interest rates will be over. High interest leads to increase in the cost of borrowing and slows investment and growth. Hence, stock markets fell.
4. Change in leadership in Federal Reserve: Jerome Powell succeeded Janet Yellen as the chairman of Federal Reserve. This change is leadership has also created some uncertainty in the markets
5. Another important reason was that most of the trades are electronic and the trading computers are often programmed similarly. They process information in the same way. Therefore, most computers had similar expectations of the future and started selling shares in bulk causing the stock market to plunge.
6. Lastly, this stock-market correction was long overdue. Stocks are still overvalued in terms of their price-earnings ratio.

To conclude, there is not much to worry as the stock markets have calmed down now, but certain analysts feel that the market is still overvalued.