A Warning Sign Behind the Market Swings

02/07/18 07:53 PM EST
By Greg Ip 

Don't worry about stock-market volatility: It is perfectly normal. Do worry about how stocks got so high to start with because it is evidence of an economy still abnormally dependent on low interest rates and richly priced assets.

The 2,271-point drop in the Dow Jones Industrial Average in the week through Monday, a decline of 9%, didn't even meet the usual 10% threshold for a correction. Tuesday's 567-point rebound didn't make the top-500 daily increases by percentage. Wednesday's 509-point swing between high and low was positively humdrum, with the Dow closing down 19 points, or 0.1%, at 24893.

Even more reassuring, the volatility is being driven by the most banal of reasons: worries about inflation and interest rates.

An inflation scare is an entirely different animal from the deflation scares that have rocked markets in the past decade, including the U.S. financial crisis of 2008, Europe's government-debt crisis of 2011 and China's slowdown in 2015. Each of those events tanked, or threatened to tank, a key economy and push inflation into negative territory. In each, investors bet on more central-bank measures to prop up growth.

This time it isn't slow growth, deflation or more central-bank stimulus that preoccupies investors, but the opposite. Last Wednesday, the Federal Reserve released a statement in which it predicted "further" gradual interest-rate increases. The word "further," which wasn't in December's statement, subtly signaled more conviction that higher rates are in order. Then Friday's report on January job growth was accompanied by the largest annual increase in wages since 2009.

During deflation scares, investors sought safety in government bonds, driving their prices up and yields down. Now U.S. bond yields are rising, standing near a four-year high as of Tuesday.

Inflation results from the economy pressing up against its productive capacity. That is a fundamentally bullish development. Higher wages and profit estimates aren't the precursors of a recession or a prolonged bear market.

True, if inflation sustainably pierced the Fed's 2% target, that would usher in much higher interest rates, and probably recession.

But why wring one's hands over the prospect when inflation, excluding the volatile food and energy categories, has been stuck below 2% for five years and hasn't hit 3% in a quarter-century?

Yet if the stock-market downdraft isn't worth fretting over, the same can't be said about the backdrop in which it happened, starting with that quiescent inflation picture. It has taken nine years and the lowest unemployment since 2000 to produce even a modest uptick in wages (and even that may prove fleeting). That shows how an aging population and lackluster productivity represent powerful and persistent headwinds to long-run growth, even if U.S. tax cuts have raised the short-run outlook.

Treasury yields are still below 3%, and below 1% when adjusted for inflation. Overseas, they are even lower. This is the consequence of a fundamentally pessimistic long-term growth outlook and of global central-bank efforts to prop up growth with low interest rates and trillions of dollars of bond purchases.

It is good news that such extreme measures are no longer needed. The Fed began raising rates in late 2015 and winding down its bondholdings last year; both the European Central Bank and Bank of Japan are moving to slacken the pace of bond buying.

But nearly a decade of ultra-easy monetary policy has sent asset prices sky-high and kept volatility unnaturally low. Even with the latest downdraft, U.S. stock values at Monday's close equaled 152% of gross domestic product, compared with 127% at the precrisis peak.

The borrowing excesses that precipitated the financial crisis of 2008 are largely absent today, yet a hunger for risk still permeates markets from bitcoin to junk bonds to real estate in Toronto and Sydney. Periodic asset booms and busts may be commonplace in a world of sluggish growth and low interest rates. Japanese stocks have experienced 14 bear markets since 1990, and six since 2008.

Even before he became Fed chairman this past Monday, Jerome Powell had observed how recent expansions ended not with inflation but collapsing asset bubbles. And they don't need to bring on a financial crisis to do damage. Goldman Sachs estimates that higher stock prices added 0.6 percentage point to U.S. growth last year via the wealth effect -- households spending their stock winnings. By Goldman's calculation, a 20% hit to prices this year could knock 1.1 points off growth. That would more than wipe out the stimulative effect of the tax cut.

There is no reason to assume this latest pullback is the start of a deflating bubble; stocks are richly valued but conceivably make sense given optimistic assumptions about growth, interest rates and volatility. But asset markets routinely overshoot their fundamentals, and that is a worry that will hang over the economy so long as interest rates and inflation remain abnormally low.

Write to Greg Ip at greg.ip@wsj.com

 

(END) Dow Jones Newswires

February 07, 2018 19:53 ET (00:53 GMT)

Copyright (c) 2018 Dow Jones & Company, Inc.