Friday, February 9, 2018

What is the Market Selloff Telling Us?

By Roy C. Smith

The US stock markets plunged 10% this week. The decline was echoed in Europe, Asia and in many emerging markets. Is this the bursting of an over-priced stock market bubble, with more to go, or just an overdue but sharp correction to a fundamentally healthy economy?

Periods of sharp stock market declines can set off panics that can spread to stocks in other countries and to other asset classes, including those not normally correlated with stocks.  If the sell offs are powerful enough, they can generate enough uncertainty in the real economy to cause recessions, as they did in 1990, 2000 and 2008. Is this one, one of those?

The trouble with bubbles is that they are always called “trends” until they burst. Investors love trends – when everyone can agree that these technology developments, or those improved economic indicators confirms their belief that the prolonged market rise is justified by underlying fundamentals.

In November 2017, Goldman Sachs published a report on the global economy entitled “As Good as it Gets,” in which it predicted global GDP growth for 2018 to be 4.0% (and US GDP growth to be 2.5%, since increased to 2.8%) due to a virtuous alignment of positive factors around the world. Many other analysts, including those from the IMF agreed. The world was finally, after many years of stimulus, cheap money and Quantitative Easing, emerging from the last of the Great Recession that had smothered economic performance since 2007.

Surely this is an event worth celebrating with a bit of market exuberance, especially in the more exciting tech areas. But the celebrating really began long before the consensus on the world economy was formed. Indeed, it all seemed to begin with the election of Donald Trump in November 2016. From then until the peak in prices last week, the NASDAQ 100 index is up 47.8%; the Nikkei 225, up 42.7%; the S&P 500, up 37.8%; Euro Stoxx, up 24.3%, and even the Brexit-burdened FTSE is up 15.5%.

Yes, the election encouraged investors to look to a market driven by deregulation, tax cuts, tougher trade policies and an infrastructure boom that might lead to growth rates in the US of 3% to 3.5%.  But not long into the Trump Administration, there were many signs of political disorder and ineffectiveness that some analysts said brought the “Trump Bump” in the markets to an end. However, the markets were continuing to rise -- not so much because of what Trump might do, but because of what he most likely wouldn’t, i.e. dissolve the health care system, create trade wars, or launch missiles at Korea or Iran. The markets could live with the disorderly parts of Mr. Trump, these analysts said, because of the overdue recovery coming through, and Mr. Trump’s pro-business side that was driving the tax bill passed at the end of the year. The market’s supporters were saying that prices were high, but not too high, because US corporate profits were up by 10% in 2017 and the tax bill would add to them.

Still, many economists were skeptical. Even on a “dynamic scoring” basis (counting incremental growth to be created by the tax cuts), the tax bill would still require at least $1 trillion of new federal borrowing over a decade, and its timing of the stimulus was all wrong and sure to increase inflation, interest rates and fiscal drag.  Then, just to emphasize this end of things, Congress further doubled the stimulus last week in passing its bi-partisan two-year budget that added an additional $1.5 billion of unfunded spending. This will boost the fiscal deficit to around 5% of GDP, and total federal debt to around 110% of GDP, the highest level since World war II.  

Indeed, those who read the Good as it Gets report thoroughly discovered that Goldman’s optimism runs out after 2018, and that for 2019, US GDP growth would drop to 1.8%, even after the benefits of the tax cuts, which, the report said, would increase GDP by no more than 0.3% in 2018 and 2019, but disappear thereafter. 

This would suggest that the markets may have risen more than they should have – animal spirits had got the best of them, as often happens. A correction was overdue and has occurred, but it takes a 20% drop over two months to mark an official bear market and we are still a long way from that. But if the spirits roil up a panic, more lasting damage might occur.

John Maynard Keynes said that panics were not so much the result of bad reasoning by individuals as by the way markets are organized and driven by groups of professionals trying to figure out what other professionals will do. The global market capitalization of equity securities today is around $80 trillion, which means a sudden increase in volatility (the 1-day VIX jumped on Feb. 5th from 11% to 37%) can shake loose a lot of profit taking, portfolio repositioning or flight to safety. The nine-year bull market was built on low volatility in a risk-adjusted environment in which stocks returned more than bonds. This may be reversing, as we return to a more normal economy with 2% to 3% inflation and higher interest rates. Normal economies are supposed to be good for business in the long run.

But if the US GDP growth is to slide back below 2% next year, maybe we shouldn’t count on returning to normal just yet.  Is a bout of low-growth with inflation out there waiting for us next?

First published in Financial News, Feb. 6, 2018

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