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Why central banks could crash the share market by 30%

Central banks could crash the share market by up to 30%.

Or, at least there’s a 50% chance of that happening according to Magellan Financial Group Ltd’s (ASX: MFG) Hamish Douglass.

Does that sound outlandish and completely negative? Maybe it is. But, Magellan’s Global Fund has been one of the most consistent outperformers in the world of the global share market over the past 10 years. I think it’s worth listening to what he says.

He has outlined two possible scenarios where there’s a 50/50 chance of either occurring.

It boils down to inflation in the US and the Federal Reserve’s response to that. With all the quantitative easing and the very-low employment rate the theory goes that inflation should pick up.

Scenario 1

Mr Douglass said there’s a 50% chance that there is no material increase of inflation in the US. If that happens then the US should see steadily rising interest rates to around 3%. There may be a bit more market volatility but it wouldn’t be too bad.

However, this would go against previous experiences in history where inflation has actually picked up when unemployment is so low.

Scenario 2

If US wage growth and inflation suddenly picks up then the Fed may find itself behind the curve and it would rapidly increase the interest rate to around perhaps 4% to catch up. If that happened we could see a share market correction of around 20% to 30%.

History would suggest this is the more likely outcome, but Mr Douglass puts a 50% chance of this happening too.

Anything else bad coming?

I haven’t mentioned (until now) the possible fallout from the central banks ending their quantitative easing programs. Generally, some people think this will also contribute to higher bond rates.

What to do?

Warren Buffett has been saying for some time that if interest rates stay low then shares aren’t expensive. If they rise, then that’s a different situation.

It’s important to remember that earnings are still growing for most companies in the US and Australia. So, even if share prices were to fall it would be a valuation correction based on the comparison to bonds, not because of recession.

Some say that the shares with high price/earnings ratios will come under pressure and also the defensive shares could feel pain too.

I think the best course of action is to stay invested in quality shares for the long-term. If you forget what’s happening with everything else and only invest in shares when you like the value then you can’t go too wrong. That’s why I’m drawn to Costa Group Holdings Ltd (ASX: CGC) and Citadel Group Ltd (ASX: CGL).

If you mentally prepare yourself by acknowledging that volatility is coming then it will be less scary if, or when, it happens.

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Motley Fool contributor Tristan Harrison owns shares of COSTA GRP FPO. The Motley Fool Australia owns shares of and has recommended COSTA GRP FPO. The Motley Fool Australia owns shares of Citadel Group Ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.