The financial markets have been on the verge of a cataclysmic financial crisis, with worrying parallels emerging between 1987's stock market crash and 2023's bond sell-off. The aftermath of the 1987 stock market crash was marked by a swift and brutal reaction from traders, with the FTSE-100 falling 11pc in a single session and the Dow Jones ending the day down by a terrifying 20pc. This event, known as Black Monday, became the worst single day of trading since the great stock market crash of 1929 and shaped policy for the rest of the decade.
As we approach October 19th, the 36th anniversary of that fateful day, there are already worrying parallels between the two eras. The bond markets are crashing around the world, just as they did in the run-up to the 1987 crash. Debts have been ramped up, and the equity markets are overstretched, with company values stretched to the point of breaking in many cases. A seemingly indestructible bull market is coming to an end, and it is not hard to see how that could end in a gale of destruction blowing through the markets.
If it came to pass, a market crash on the scale of 1987 would prove a cataclysmic political and economic event. It would send interest rates soaring, increasing costs for mortgage holders and highly indebted companies, especially in the property sector. Business would fail, pension funds would be hard, and the already-high cost of servicing national debts would climb even higher. It would force profligate politicians to finally face up to the consequences of their wild spending.
There is plenty about the financial markets over the last few weeks that looks very similar to the late 1980s. There is, however, an important difference. Policy makers still had fiscal room to respond to the crash of Black Monday. After two decades of easy money and constant buffering of the markets with quantitative easing to prevent a crash, that no longer exists.
Investors are beginning to worry about a repeat of Black Monday primarily because of a sell-off in the bond market, where companies and governments issue debt and promise a guaranteed rate of return. Most of the major bonds have fallen in value on a spectacular scale over the last few months, with the losses accelerating over the last month.
The crisis is most often measured in yields – the rate of return offered by a bond, which moves inversely to price. Yields have spiked to levels that even seasoned market professionals can barely remember. In Britain, the government is now paying above 4.5pc on a 10-year gilt, significantly more than when Liz Truss supposedly "crashed" the economy a year ago.
In total, the global bond market is worth $133 trillion (£109 trillion), or rather it was when it was last properly measured in 2022. When it crashes, it has far more impact on the everyday economy than any other part of the financial system.
The Covid pandemic and the war in Ukraine have led to a significant spike in inflation, which has become resistant to higher interest rates. Central bankers have acknowledged that inflation has become embedded in the same way it did in the 1970s, and that rates will have to stay higher for longer to control that again. As a result, bonds have been massively repriced, even five or ten years out, for a world in which money is far more expensive than it has been for a generation.
Stock markets remain wildly over-stretched by any historical comparisons, meaning they have much further to fall if a crash does materialize. There are plenty of signs of stress in the financial markets, such as the first tremors felt in the UK in the wake of the mini-Budget last September. The markets were unnerved by the scale of the borrowing planned by the Government, leading to a sterling crash and spiked borrowing costs.
The surge in bond yields triggered the LDI crisis, with pension funds over-committed to instruments that assumed bond markets would not move for years. A fire sale began and the Bank of England was forced to step in and stop things spiraling out of control. There are plenty of warning signals elsewhere as well, such as the collapse of Silicon Valley Bank in the US, the growing property crisis in Germany, and China's debt-fueled property bubble.
If the financial contagion does spread, the main casualties are not hard to work out. In the UK, we have already witnessed a steep rise in mortgage rates and some modest falls in house prices, but if there is a full blown crash it will get much worse. In the US, the average mortgage rate has hit 7.5pc, the highest level since the millennium. House prices are falling at an annual rate of 7pc in Germany, the steepest decline in 23 years.
A market crash will be felt by companies that borrowed cheaply and complacently assumed that rates would never rise again, especially in the private equity industry. The sector bought up huge swathes of the economy with cheap money and will have to start selling at huge losses once all that debt has to be refinanced at far higher rates.
The main casualties will be felt most painfully by governments, as they have borrowed so much over the last decade. In the UK, the cost of servicing our huge debt mountain has risen to £100 billion a year, double the amount only a year ago, and almost 11pc of total government spending. In France, debt costs are now the biggest single budget item, forcing the free-spending Macron government to make savings elsewhere.
In the US, interest payments on the national debt are forecast to rise from $475 billion last year to $1.2 trillion by the end of the decade. All major governments across the developed world will have to start cutting their spending and reducing their borrowing simply to bring their cost under control. Add it all up, and it will be very tough to adjust to higher rates.
The 1987 Black Monday crash may have been a significant event in the history of Western economies, as it marked the beginning of the Reagan-Thatcher project of rebooting the Western economies. However, the current state of affairs is far different. In 1987, overall debt levels were lower, and government debts were less burdensome. The US and UK had lower debt to GDP ratios, higher interest rates, and less debt for households and companies, which allowed them more flexibility to cope with the crash.
Governments had already started making their economies more competitive, which was just starting to pay dividends. The loosening of financial policy in the wake of the crash led to inflation, which arguably led to the fall of the Thatcher administration in 1990 and the defeat of Reagan's successor, Geoge HW Bush in 1992. However, this did not happen today. All Western economies have been steadily enfeebled over the last fifteen years, with state spending growing exponentially, regulation increasing, governments being captured by lobby groups, and corporations falling under ideologically driven managers committed to social values instead of innovation and growth.
The 2023 crash may mark the point at which two decades of relentless government expansion, increased welfare entitlements, and soaring debt levels, all financed by cheap money, start to unravel. Governments, corporations, and households will have to start living within their means again, and growth will only be possible through greater innovation and productivity instead of printed cash.
Looking back from the 2030s or 2040s, a collapse may be seen as a good thing, forcing us to focus on restoring real growth. However, there will be a lot of pain getting to that point, as seen in bond markets over the last few weeks.
This article is republished from The Telegraph. Click here to read original article.
