Stock market trouble ahead? | The Hill

Should stock market investors lose money next year, they won’t be able to say they weren’t warned by the world’s major central banks.

First, Federal Reserve Chairman Jerome Powell warned that easing inflation may require a long period of high interest rates and below-trend economic growth. Now both the Fed and the European Central Bank are warning of increased risks to the global financial system.

Indeed, in the words of the Fed’s recent Financial Stability Report, “the rapid synchronous global monetary policy tightening, together with rising inflation, the ongoing war in Ukraine and other risks, could lead to the amplification of vulnerabilities, for example due to strained liquidity in core financial markets or hidden leverage.”

Stock markets seem to go through periods of forgetting that long-term stock market prices are determined both by the expected stream of company earnings and by the interest rate at which those earnings are discounted. The lower the expected earnings stream, the lower the long-term stock market price will be. The lower the interest rate, the higher the share price will be for any given earnings stream.

Also Read :  Big 12 Conference Forms Business Advisory Board Comprised of Entrepreneurial Icons and Industry Leaders

Today we seem to be going through one of those periods where the stock market is largely focused on the interest rate outlook and mostly forgets about the earnings outlook. Riding its impressive 10 percent rally from its September 2022 low, the stock market is increasingly expecting that as inflation data improves, the Fed will turn away from its current monetary-policy hawkishness. If the Fed does turn, interest rates will be lower next year than they otherwise would have been.

To be sure, if earnings were to hold, a Fed pivot would be good for stock market prices in that it would lead to lower interest rates at which company earnings would be discounted. However, a very different story would emerge if the reason for the Fed’s pivot was the prospect of a significant economic recession or a global financial crisis. In those circumstances, the downgrade of earnings outlook is likely to swamp any benefit to stock prices from lower interest rates.

Jerome Powell has been clear in his determination to keep interest rates high enough for as long as necessary to reduce inflation from its current 7.7 percent level to the Fed’s 2 percent inflation target. As former Treasury Secretary Larry Summers never tires of reminding us, it is highly unlikely that such a large reduction in inflation can be achieved without producing a significant economic recession.

Also Read :  Asia shares mixed on Fed warning, China hopes

The bond market seems to be grasping the high probability of a recession next year by sending short-term interest rates well above long-term interest rates. By contrast, stock market analysts seem to ignore that probability by barely downgrading their earnings forecast.

Making the stock market’s current complacency all the more difficult to understand are the Fed’s and ECB’s express warnings of heightened global financial market risk at a time of synchronous monetary policy tightening, high inflation and geopolitical tensions. The market’s apparent complacency is harder to understand given the many cracks already emerging in the world’s financial system.

Over the past year, China’s Evergrande, with $300 billion in debt, and 20 other Chinese property developers have defaulted on their loans. In the United Kingdom, the Bank of England had to bail out the British pension system last month with a $65 billion intervention in the British gold market to save it from ill-advised derivative positions. Meanwhile, emerging markets Argentina, Russia, Sri Lanka and Zambia have all defaulted on their debt. More recently, the cryptocurrency market was rocked by the run on FTX, a cryptocurrency trading platform.

Also Read :  Today's Mortgage, Refinance Rates: Nov. 14, 2022

Maybe this time we will be lucky and markets will continue to recover despite a recession and despite any financial market crisis. However, if the pessimists turn out to be wrong in calling for real stock market trouble ahead, they can defend themselves by saying that all the clues and historical experience point in the opposite direction.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s policy development and review department and the chief emerging market economic strategist at Salomon Smith Barney.


Leave a Reply

Your email address will not be published.

Related Articles

Back to top button