How can the stock market fall when the world economy is doing so well?
At first glance, the prospect of a plunge in equity prices seems counter intuitive at the moment. Global growth is going better than expected a year ago. And that should be good news for company profits worldwide.
The problem is that the good news is already ‘in the price’. In other words, it’s already been discounted. So if anything goes even slightly awry, global stock prices could be vulnerable to a major pullback. Even if it doesn’t, there‘s little upside…
World trade rose 4.5% in three-month year-on-year terms in November, according to the Netherlands CPB Bureau. And January’s preliminary business surveys from data monitor Markit “suggest that economic growth in advanced economies may have gained even more momentum at the beginning of the year”, says Capital Economics.
Manufacturing readings across the Eurozone, the US and Japan, at near eight-year highs, “are consistent with GDP growth in advanced economies of over 4% annualised.”
Compared to 18 months back, that’s a real turn up for the book!
Sure, loads of extra liquidity has been pumped into the system via asset purchases by central banks since the great financial crisis a decade ago.
But for years, it didn’t seem to be working in jump starting economic growth.
Now, it seems, it is.
And just as that’s happening, along comes Donald Trump.
Eight years into the economic recovery, America’s government is now betting big on the fiscal front. Tax cuts and another surge in the state deficit are all the rage.
If the US wanted to go down this path, it should have done it before. Like in 2009-12, as the economy was plodding – not now, when asset prices keep hitting new highs.
Meanwhile, even more financial juicing is being planned over on Stateside.
“The Federal Reserve is working to relax a key part of post-crisis demands for drastically increased capital levels at the biggest banks, a move that could free up billions of dollars for some Wall Street’s giants”, reports a Bloomberg source. “Central bank staffers are rewriting the leverage-ratio rule – a requirement that US banks maintain a minimum level of capital against all their assets”.
Err…does this remind you of anything – such as what happened 10 years ago? Is increasing leverage at this stage of the cycle really a good idea?
I’ve recently written in DR about the massive jump in global debt during the last decade. Now, to lapse into economist-speak, both credit and fiscal policies have turned expansionary at the same time. The net effect is that to fund more growth, the world is set to owe itself even more than the vast amounts it has already borrowed.
Trouble is, as any debtor knows from experience, this trend can’t continue forever.
Those central bankers have started to clock that they need to turn off the money taps. Or at least, reduce the flow.
Financial markets may appear to have operated in a parallel universe for the last few years. To repeat, the prices of assets such as shares and bonds have kept climbing.
“You aint seen nothing yet…”
Here’s the chart of the US Treasury 10-year yield, the world’s most watched long-term interest rate (for which many thanks to FRED, the US Federal Reserve Bank of St Louis), over the last 55 years.
Since the early-1980s, the 10-year yield has been dropping steady (i.e. US Treasury bond prices have risen). Inflation has fallen sharply and the events of a decade ago – shown by the most recent shaded area indicating a recession) intensified the decline.
Yet since September 2017, the picture has begun to change. Over that period the 10-year yield has jumped from around 2% to 2.7%. Put another way, as the pace of central bank asset purchases has ebbed, the fixed income market has cottoned on. Less bond buying has meant lower prices along with higher yields.
And as Bachman Turner Overdrive said in 1974, “you ain’t seen nothing yet”.
Looking forward over the next 12 months, the rate of central bank asset buying is set to drop a lot more. That’s likely to be accompanied by a further rise in 10-year yields.
What does this mean for the global economy and stock prices?
Depending on its extent, an increase in long-term interest rates to more normal historic levels may prompt another recession. That said, the world economy may continue to expand fine. But for equities, the effect could be much more dramatic.
As capital competes for the best returns, a sharp rise in bond yields is generally bad for shares. With the latter going up so much as central banks have helped out, it’s a pretty good bet that they’ll now drop as the converse becomes true.
Analysts at Citi have been studying the potential effects of the correlation. They reckon that mid-2019 equities are facing a near-50% drop to keep up with central bank asset shrinkage.
For a final word on this topic, it’s over to billionaire American investor Howard Marks, chairman of ‘distressed debt’ fund Oaktree Capital.
Mr Marks is the sort of investor whose work I like to read. He’s clear thinking, contrarian and with a bias to being bearish, though not obsessively so. And last week he published his latest ‘memo’ to Oaktree clients – typed out in typically no-frills style, which I also like – on his current market thoughts.
In recent months I’ve discussed many of the issues he raises, so I’ll not spend much time on them here. But there are a couple of comments worth noting.
“Most valuation parameters are either the richest ever among the highest in history. In the past, levels like these were followed by downturns. A decision to invest today has to rely on the belief that ‘it’s different this time’. Prospective returns in the vast majority of asset classes are some of the lowest in history. The easy money has been made.”
In short, the good news for stocks is already baked into the price. Mr Mark’s wary tone makes a lot of sense. As does gold, still the classic safe haven in troubled times.