Are we heading for global financial meltdown?

Could the current slump turn into a crisis? Here are two different perspectives.

After just three weeks of 2016, this year has seen the worst start to a January in British stock market history. Indeed, after only 14 trading days and at Thursday's close, the FTSE 100 index was already down almost 470 points (7.5%) this year.

Stock markets are falling because nervous investors are selling shares, while others are fearful to buy. Naturally, this selling pressure causes prices to fall, which triggers more rounds of selling in a vicious circle. These falls are being seen all over the world, with markets in New York, Tokyo and Shanghai also heading steeply southwards.

This tsunami of selling has been triggered by various worries, most of which are foreign, rather than domestic. One oft-quoted concern has been the steep fall in Chinese stock markets, which are down roughly 40% from their summer peak.

A second reason is the sudden and steep depreciation of China's currency, the renminbi (or yuan), which hurts emerging markets that trade with it. In addition, the world's second-largest economy last year recorded its slowest economic growth since 1990, with gross domestic product rising by 6.9%.

Another concern is the global economy is experiencing a mild slowdown as trade turns sluggish. The International Monetary Fund (IMF) has cut its latest estimate for world economic growth in 2016 to 3.4% from 3.6%. And with company profits hitting record highs in many business sectors, there are fears that corporate earnings (and share dividends) may weaken in 2016.

Lastly, and perhaps most crucially, the Federal Reserve, the US central bank, raised interest rates in December for the first time since 2006. This tightening of monetary policy has spooked shareholders, who have grown accustomed to years of rising markets, backed by loose monetary policy and quantitative easing (so-called 'money-printing').

In summary, optimism is in pretty short supply among investors at the moment. Hence, they are erring on the side of caution by selling out and sitting out further falls on the sidelines.

The big question now must be: is this just a bear market, or are investors facing a full-blown slump? Let's look at the arguments for and against this scary scenario.

The case for a crash

As an investor with almost three decades of experience, I'm going to put the bear case first. I've been gloomy about prospects for share prices since last spring, when the FTSE 100 first climbed above 7,000 points. To me, shares are still somewhat overpriced, given the prospects for future growth in corporate profits and dividends.

My view is that, since 2009, asset prices have become artificially over-inflated, driven upwards by a wave of cheap money flooding the markets from central banks in the US, UK, Europe and Japan. With US interest rates on the turn, this supply of cheap credit may start to dry up, removing liquidity from markets and driving share prices down.

Second, analysts from Royal Bank of Scotland (RBS) released a report a week ago that told clients to 'sell everything' except high-quality bonds before a 'cataclysmic' year for asset prices. RBS claims that current events are an echo of 2008 and, therefore, share prices have much further to fall. For example, it predicts that share prices will fall by at least a fifth (20%) this year, so we are merely a third of the way through this slump.

In addition, RBS warned that sustained falls in the prices of oil and other commodities have some way to go. It reckons that the price of Brent Crude could fall to $16, roughly half its current level of $31 and down a shocking 86% from its June 2014 peak of $115. If this happens, then expect shares in oil producers and explorers to hit rock bottom.

What's more, supposedly safe dividends from the likes of mega-caps Royal Dutch Shell and BP could be cut if the oil price continues its nosedive. Similarly, brutal falls in the prices of base metals and other commodities will do horrible damage to shares in miners. Investors in energy and commodity stocks are set to face continued hardship as stock prices repeatedly hit new lows.

In short, for 2016, investors should be more worried about the return of their capital than the return on their capital!

Reasons to be cheerful

On the other hand, there may be some light at the end of the tunnel. Generally speaking, full-on stock-market crashes tend to be accompanied by economic recessions (with the notable exception of October 1987), of which there is no sign at present. Similarly, the plunge in the oil price has made fuel much cheaper, putting much-needed disposable income into consumers' pockets.

Laith Khalaf, Senior Analyst at investment firm Hargreaves Lansdown, is optimistic about future returns for UK shareholders. He argues: "This current situation won't make for pleasant reading for investors looking at their pension and ISA statements right now. However, stocks are prone to periodic setbacks and those who have invested in equities need to keep their heads when markets take a tumble. Being greedy when others are fearful is easier said than done, but it's a maxim which is well observed at times like these."

Khalaf adds: "Maintaining perspective is also important. While the stock market has had a bad run of late, longer-term investors have still enjoyed a reasonably positive return, despite the recent sell-off. It's really important when interpreting these numbers to bear in mind that they are comparing the market now to its very peak last April, so the starting point is an extreme value.

He continues with this advice to investors looking to 'buy on the dips': "Hold your nerve. Prices may yet have further to fall, but history tells us the market will at some point recover, even if this takes some time. If you sell out each time the market tumbles and buy back in once the clouds have cleared, you are likely to significantly reduce your overall investment returns."

"Investors who are going bargain-hunting should always seek out companies with good long-term prospects trading at attractive prices, not just companies which have suffered heavy price falls. In particular, while oil and mining stocks are looking bruised and battered, we would urge caution when investing, because the revenues of these companies depend on commodity prices, which show no sign of reversing their recent trend."

Summing up, Khalaf concludes: "Consider topping up. Over the long term, the best time to buy is usually when it feels really uncomfortable and, on that basis, adventurous investors with a long time horizon could look at the current situation as an opportunity. However, don't expect your purchase to signal the bottom of the market. If you are investing in this way, you need to be willing to see your investment fall further, rather than expecting instant gratification."

So Khalaf believes that, although recent share-price falls may continue, there are long-term bargains waiting to be had for investors willing to do their homework and buy cautiously into good, solid businesses. Only time will tell which of us is right.

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