How much should we be worrying about the Wall Street sell-off this week?
This isn’t a question that only investors should be concerned with. Trends on stock markets happen for a reason. Sudden, sharp drops may be a factor of the herd mentality, but a long-term decline in share prices and valuations is more likely to reflect the considered opinion of the investment community.
That being the case, the fact that U.S. stocks swooned over the first two days of this week, wiping off $1 trillion off the market value of the top tech shares, isn’t by itself a reason to be on edge.
More worrying is that a key market index, the S&P 500, has fallen close to 10% since the start of October.
Lots of other metrics also suggest that the people with money are worried about where the U.S. and world economies are heading.
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Without getting too technical, one key number shows that investors are growing more pessimistic about corporate valuations on the market relative to forecasts of their earnings. This year, that ratio has tumbled 17%, almost as much as it did during the 2008 financial crisis.
Another useful number (this one is from the bond market and then we’ll leave off the numbers) is the yield curve on U.S. treasuries, which shows the difference between the yield on two-year bonds versus 10-year bonds. Normally the longer-term bonds pay more than the shorter-term ones; when they reverse, that often points to a recession on the horizon. Right now the curve isn’t inverted, but it is getting perilously close.
Nine of the last five recessions
The capital markets aren’t infallible when it comes to calling the future direction of the economy. As the economist Paul Samuelson once quipped, “The stock market has forecast nine of the last five recessions.”
Also, a cursory look at the U.S. economy offers little reason to worry: GDP is growing at its fastest in more than a decade, the unemployment rate is at a half-century low, corporate profits are expected to show a 28% jump in the third quarter and even labor productivity is rising.
Now you may ask yourself why everything looks so damn good, and then start wringing your hands.
The answer is mostly Trump and his $1.5 trillion in tax cuts. They slashed the tax bill of U.S. businesses, and, to a lesser extent, of consumers. But meantime, Trump raised spending and the Federal government’s deficit in the year ended in September ballooned by 17%.
Naturally when people and businesses are paying less tax and buying more, and the government is spending more borrowed money, the economy is going to grow. But that’s not a formula for sustainable economic growth any more than a sugar fix is the basis for a healthy diet.
Trump and the Republicans sold the tax cuts as a long-term plan to revive investment, which in turn would bring long-term growth. So far, however, it hasn’t turned out that way. A brief surge of spending on new factories, machinery and computers earlier this year has faded and increased corporate profits have mostly gone to shareholders as stock buybacks and dividends.
Certainly any investor with a modicum of perspective could see that the boom isn’t sustainable, but few were willing to stay out of a market that has been performing so well.
It’s like the man on death row getting his final meal. He knows his fate is sealed, but he might as well enjoy the culinary experience while he can. Going hungry in his last hours won’t make him happier.
The Chinese risk factor
The forecasters says that the Trump tax boom won’t lead to a blowout but to slower growth – the Organization for Economic Cooperation and Development saying this week it would trend down from 2.9% this year to 2.1% in 2020. That’s quite reasonable, but the risk that things will go wrong is long enough to provoke anxiety in the markets.
The OECD acknowledges that in language so discrete you might easily overlook it that “rising risks could undermine the projected soft landing from the slowdown.” A hard landing doesn’t have to be a repeat of 2008, but it won’t be comfortable.
Trump is one of those risks. The trade war with China may eventually go America’s way, but he was wrong in saying it would easy to win. In fact, it could turn into a lose-lose situation if the Chinese economy suffers a severe slowdown and drags the world economy with it.
China is vulnerable to high levels of corporate debt that borrowers will struggle to pay if its economy slows. As General Electric’s recent problems illustrate, America has the same problem. In any case, the U.S. Federal Reserve is raising interest rates, which will only exacerbate the problem. Emerging markets like Turkey, Argentina and Brazil are in bad shape and their problems could easily spread.
When a crisis comes, Trump is not the person you want to be in the Oval Office.
If it were only him, maybe the Washington establishment could marshal the resources to act, but a scenario like that seems unlikely. Trump hasn’t surrounded himself with the best and brightest on economic policy, and his testy relationships with America’s allies will complicate making a coordinated policy response in a crisis.
The stock market cheered the mid-term elections, but the truth is that the vote created a partisan gridlock that will make it difficult for Congress to cope.
Wall Street can’t count on Washington to manage the dangers ahead.