Stock market problems ahead? | The hill

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

First, it was Federal Reserve Chair Jerome Powell warning that bringing down inflation may require a prolonged period of high interest rates and below-trend economic growth. Now it is both the Fed and the European Central Bank warning the increased risks for the global financial system.

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

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

Today we seem to be going through one of those phases where the stock market largely focuses on the interest rate outlook and largely forgets about the earnings outlook. With the impressive 10% rally from its September 2022 low, the stock market is increasingly expecting the Fed to backtrack from its current tight monetary policy as inflation data improves. If the Fed does turn around, interest rates next year will be lower than they otherwise would have been.

Of course, with earnings sustained, a Fed pivot would be good for stock market prices as it would result in lower interest rates discounting corporate earnings. However, a very different story would ensue if the reason for the Fed’s pivot was the prospect of a major economic recession or a global financial crisis. In these circumstances, downgrading earnings prospects would likely negate any benefit to stock prices from lower interest rates.

Jerome Powell has made clear his determination to keep interest rates high enough to bring current inflation down for as long as necessary 7.7 percent on the Fed’s 2 percent inflation target. As a former Treasury Secretary, Larry Summers never tires remind usit is highly unlikely that such a large reduction in inflation can be achieved without triggering a major economic recession.

The bond market appears to be realizing the strong possibility of a recession next year, sending short-term rates well above longer-term rates. In contrast, stock market analysts seem to ignore this probability, rarely revising their earnings forecasts downwards.

The current complacency of the stock markets is all the more difficult to understand given the explicit warnings from the Fed and the ECB of increased global financial market risk at a time of simultaneous tightening of monetary policy, high inflation and geopolitical tensions. The market’s seeming complacency is harder to understand given that many cracks are already emerging in the global financial system.

Over the past year, China’s $300 billion debt-earning Evergrande and 20 other Chinese real estate developers have done so defaulted on their loans. In the UK, the Bank of England fell last month get out the UK pension system with a $65 billion intervention in the UK gilt market to shield it from ill-advised derivative positions. Meanwhile, Argentina, Russia, Sri Lanka and Zambia have all emerged in the emerging markets defaulted on their debts. More recently, the cryptocurrency market has been rocked by the run on FTX, a cryptocurrency trading platform.

Maybe we’ll be lucky this time and the markets will continue to recover despite the recession and the financial market crisis. However, should the pessimists prove wrong when they predict real stock market troubles, they could defend themselves by arguing that all the evidence and historical experience points in the opposite direction.

Desmond Lachman is a Senior Fellow at the American Enterprise Institute. He was Associate Director in the Policy Development and Review Division of the International Monetary Fund and Chief Strategist for Emerging Markets at Salomon Smith Barney.

Leave a Reply

Your email address will not be published. Required fields are marked *