Michael Baxter share's his thoughts on the recent turbulence in the stock market
The dilemma at the heart of stock market wobbles
Ever since central banks cut interest rates to record lows and unveiled quantitative easing, bears have been warning that it will end in disaster. Then, just as central banks started to take on a more hawkish veneer, stock prices tumbled, apparently confirming those darkest fears. But is it really that bad?
Question: what do you do when the party you have thrown starts to get rowdy? Do you get out more drink, pour more vodka into the punchbowl, or do you act the responsible host, and start mixing the drinks with more water?
Alan Greenspan, ex, ex, ex, chair at the FED, once said it was the job of central bankers to take the punchbowl away just as the party gets going.
The question is, did central banks leave it too late to remove the punchbowl, and for that matter did they make it too strong in the first place?
Right now, the conditions are practically classic. Unemployment has fallen to exceptionally low levels in the US, UK and Germany, the economies in the US and Germany - at least - seem set to see the strongest growth rate in years. These are the conditions that normally lead to higher inflation, precipitating significant hikes in interest rates.
So, this begs the following questions:
- Is inflation really set to surge?
- How high will rates go?
- What will the effect be if rates rise to anything like the levels once considered normal?
And to answer those questions, let’s start with a couple of dilemmas. This morning, I read that in Germany, where unemployment is at just 3.6 per cent, real wages saw their weakest growth rate last year since 2013. It should not be like that, with unemployment that low you would expect wages to go through the roof.
Okay, there is industrial action gathering pace in Germany right now, but even so, such weak wage growth when unemployment is so low is extraordinary.
And we can say ditto for the UK and US.
Economic theory tells us that wages should be shooting up creating an inflation spiral.
Maybe in the UK, things have changed thanks to the long run effect of Thatcherism destroying the power of the unions, maybe it is because of the creation of the so-called gig economy - an army of zero hour and freelance workers who have little say on how much they are paid. Maybe unemployment is so low and yet wage inflation so weak, because the labour market, for good and bad, is ultra-flexible.
But the nagging fear won’t go away: with unemployment this low, won’t this all change - as the available labour pool becomes scarcer, surely wages will rise.
Stock market fears
On top of these fears, we have President Trump’s tax cuts and infrastructure investment plan, such as it is, and you can see why central banks seem to be getting itchy.
And it was these fears over higher interest rates that led to stock market falls.
Rates and equity values
When it comes to the stock market: interest rates matter for several reasons. When bond yields are low, equities look relatively cheap, so their price goes up in response. There is a more subtle effect too. A company’s valuation is meant to be calculated by projecting future dividends and discounting them by a rate of interest to create a net current value. If the expected long-run interest rate falls, equity prices should rise, as happened post 2008. If expected long-run rates increase, equity prices should fall.
In 1987, at a time when US interest rates were rising, stock markets crashed. Rising rates, aside, there seems to have been no good reason for the crash, and stocks did recover quite quickly. Even if you had bought into stocks on the eve of the crash, you would have been seeing a positive return within a couple of years.
So, was last week’s sell-off like a mini 1987 crash?
For me, it all boils down to productivity. Growth in productivity has been lousy for years - with unemployment as low as it is, with the backlash against immigration in the US and UK, the only way growth can be maintained, without sharp rises in inflation and much higher rates, is if we see productivity growth rise much higher.
And that is something I would like to explore in a later article.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.