The stock market slide
The stock market dropped last week, leading to questions and debates as to the underlying reasons. We review economists’ views on the issue.
John Cochrane has a long explanatory post on “stock gyrations”, where he examines in depth stock prices, price dividend ratio, rates, risk premium and volatility. The question before us is, are long-term real rates finally rising – back to something like the historical norm that held for centuries – and if so why? The good story, Cochrane argues, is that we are entering a period of higher growth. This would raise real growth, with a small stock price decline, but higher stock returns and bond returns going forward. The bad story is that, having passed a tax cut that left untouched will lead to trillion-dollar deficits, congressional leaders just agreed to $300 billion more spending. Cochrane argues that at some point bond markets say ‘no’, and real rates go up because the risk premium goes up. The good news leads to some inflation if you believe in the Phillips curve. The bad news leads to stagflation in a tight fiscal moment.
Tyler Cowen builds an argument whereby a decline in asset prices can be seen as a good thing even outside the framework of a bubble. He argues that these high asset prices do reflect a reality of wealth creation, i.e. the fact that there is an imbalance between world wealth and safe ways of transferring that wealth into the future. The stock markets of China and Russia are unsafe and not well developed, and many other emerging economies, such as Turkey and Brazil, have been wracked with uncertainty and political turmoil. So in relative terms, the high-quality, highly liquid blue-chip assets will become expensive and we end up with especially high price-to-earnings ratios and consistently negative real yields on safe government securities. As positive reports spread throughout the American economy, blue-chip assets may become less important as relatively safe stores of value and so their prices might fall. Those price patterns don’t have to be bubbles, but in a world where wealth creation has outraced the evolution of good institutions, they may signal that the risk premium may be more important than you think.
Paul Krugman says that, on one side, we should not assume there was a good reason for the market slide – when stocks crashed in 1987, it turned out it was self-fulfilling panic. On the other side, we should not assume that the stock price decline tells us much about the economic future, either – the 1987 crash, for example, was followed by solid growth. Still, market turmoil should make us take a hard look at the economy’s prospects. If there was any news item behind the slide, it was the recent employment report, which showed a significant although not huge rise in wages. Krugman argues that this is good news – as is the evidence that the U.S. economy is nearing full employment – but it does also mean that future U.S. growth can’t come from putting the unemployed back to work. He argues that at the very least America is heading for a downshift in its growth rate and that the available evidence suggests growth over the next decade will be something like 1.5% a year, only half as fast as Trump promises.
Matthew Klein on FT Alphaville looks at the market’s fear that faster wage growth will lead to faster consumer price inflation, or at least to the Fed tightening in response to the fear of inflation. He argues that the latest figures do not actually validate what traders are thinking. Taking a six-month average actually suggests that wage growth has slowed ever so slightly since the second half of 2016. There are also reasons to wonder how much of this wage growth is going to actually flow through to consumer spending: in general, people on lower incomes tend to spend more and save less, so those worried that higher wages will boost consumer purchasing power and erode margins should focus on the lower-paid sectors, but wage growth there has actually been slowing down. Klein also points to the importance of the financial sector with respect to wage growth, and argues that it would be ironic if financiers convinced themselves to sell stocks because of a single data release, which had been distorted by their own aggressive pay packets, which in turn were based on a market melt-up partly justified by the stability of inflation.
Stephen Williamson at New Monetarism thinks that there is not really any sign of excessive inflation in the data. There are indeed signs that inflation, and anticipated inflation, are very close to what is consistent with a 2% inflation target, for the indefinite future. He thinks that there may be potential risk in terms of monetary policy decisions, though, as the Fed is as close as it typically gets to achieving its goals. Inflation has been coming up recently, as nominal interest rates have gone up. That’s consistent with Neo-Fisherian logic – increase the nominal interest rate if you want more inflation. Of course, inflation was low in 2014-2015 in part because of a fall in the price of crude oil. Nevertheless, some people were arguing that inflation would go down as a result of the Fed’s interest rate hikes, and that certainly hasn’t happened. The problem is that the Fed could continue to increase interest rates when this is not warranted, overshoot inflation, and continue to hike, thus overshooting even more. Fortunately, that’s a politically difficult route to take, so he doubts it would happen.
Dambisa Moyo argues that, despite the recent slide, the mood supporting stocks remains out of sync with the caution expressed by political leaders, while the market is mispricing perennial structural challenges – in particular, mounting and unsustainable global debt and a dim fiscal outlook, particularly in the US, where the price of this recovery is a growing deficit. As 2018 progresses, business leaders and market participants should – and undoubtedly will – bear in mind that we are moving ever closer to the date when payment for today’s recovery will fall due. The capital market gyrations of recent days suggest that awareness of the inevitable reckoning is already beginning to dawn.
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