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Markets confront death by a thousand cuts


By A Gary Shilling

Stocks have been on a wild ride, with the Dow Jones Industrial Average dropping 10.4 per cent from its peak on January 26 to the February 8 trough, before recovering about half those losses through Thursday. Usually, big declines foreshadow Federal Reserve induced recessions. Late in a business cycle, the central bank worries about economic overheating and jacks up interest rates to crushing levels.

That wasn’t the case during the dotcom bubble in the late 1990s, when the Fed belatedly boosted the federal funds rate from 4.75 per cent to 6.50 per cent between June 1999 and May 2000. Similarly, central bankers waited too long to raise rates despite clear housing-market excesses in the early 2000s that enabled the subprime mortgage boom, which precipitated the financial crisis and the 2007-2009 recession. At the time, the rate increases didn’t start until mid-2004, rising slowly in quarter-point increments from 1 percent to 5.25 per cent in mid-2006. It was too little, too late.

It’s no surprise that stocks have been floating on a sea of money created by the Fed and other monetary authorities ever since they bailed out the major banks during the financial crisis and then turned to massive quantitative easing. It’s also fueled private equity and hedge fund inflows despite poor performance, leveraged loans, bitcoin speculation and emergingmarket stocks and bonds. The market capitalisation of the S&P 500 Index is 150 per cent of gross domestic product, well above the 2007 pre-crisis peak of 137 per cent . Nobel laureate Robert Shiller’s cyclically adjusted price-to-earnings rate was 33.8 in January, the highest since the 1929 crash and twice the 16.8 long-term average.

The consensus is that the recent selloff can be tied to the unwinding of bets that volatility, which has fallen to historic lows, would stay depressed for an extended period. Successes in these trades encouraged more of the same, until speculators were forced to buy back their shorts and the feedback loop reversed. This was a classic case of too many being on the same side of the same trade at the same time.

The parallel today may be 1987, when the Dow nosedived 22.6 on October 19 — Black Monday. The culprit was portfolio insurance, the belief that equity portfolios could systemically be sold to preserve profits in the event of market declines. That encouraged risk-taking. But with so many portfolio insurers, buyers were all too few when sellers simultaneously wanted to bail. The self-feeding upward cycle proved more virulent on the downside.

To be sure, I see no inflated bubbles that the recent volatility-induced stock declines could prick and then precipitate a recession — nothing like the dot-com or the subprime mortgage excesses. But there are enough imbalances that could lead to death by a thousand cuts, especially if stocks fall much further.

Goldman Sachs believes that the 19.5 per cent climb in stocks last year accounted for 0.6 percentage point of the 2.6 per cent real GDP growth via the wealth effect as households spent some of their portfolio gains. The firm believes a 20 per cent drop in stock prices would cut GDP growth this year by 1.1 points.

Then there’s the Fed, which, under the new chairman, Jerome Powell, may be more aggressive in raising the fed funds rate. Many investors worry about inflation and have pushed up the spread between 10-year Treasury Inflation-Protected Securities and conventional Treasuries of similar maturity from 1.34 per cent in June 2016 to a recent 2.07 per cent .

The height of inflation concern is also shown by the emphasis on the 2.9 per cent rise in hourly wages in January from a year earlier, even though most of the gain went to supervisors, not rank-and-file workers. And the decline in the work week in January held the rise in weekly wages to 2.6 per cent .

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