After another week of exceptional volatility on Wall Street that has pummelled stock portfolios, there are two closely related questions worth asking.
First, why is this happening when the economy is so strong? The November U.S. jobs numbers released on Friday showed the unemployment rate remains at a rock-bottom 3.7 per cent amid healthy job creation, just the latest piece of economic data to come in relatively strong.
Second, what took so long? Why are markets just now recognizing the risks the economy faces in 2019, which have been obvious for months to anyone paying attention?
The forces driving the recent swings – which have resulted in an 8-per-cent drop in the S&P 500 over the past two months, with some teeth-rattling ups and downs for stocks, bonds and major commodities along the way – are not anything new.
First, three years of interest-rate increases by the U.S. Federal Reserve are finally starting to pinch interest-rate sensitive sectors, particularly housing, the auto industry and companies with heavy debt loads. After years in which the economy has become heavily tilted toward industries that depend on low interest rates, a potentially painful rebalancing is under way.
Second, investors worry that the trade war between the United States and China could start to pinch corporate earnings and economic activity more than it has to date. But that conflict has been building throughout 2018.
Third, the tax cut that has lifted corporate earnings and economic growth in 2018 won’t be repeated in 2019, meaning a harder slog for companies seeking higher profits. Growth will slow unless companies develop ways to extract greater productivity from their (increasingly hard to find) work force, which would be great for long-term economic prospects, but isn’t the kind of thing you want to count on.
So the answer to the first question – of why markets have become so turbulent when the U.S. economy is strong – is the simpler one. Markets look forward and the risks looking forward seem increasingly ominous even as everything continues to go swimmingly, especially in the labour market, as 2018 nears its end.
The second question is a little harder. All of these major risk factors have been openly discussed among economists and the financial media for the past year.
The consensus economic projections of Fed officials published one year ago show that they expected the economy to grow 2.5 per cent in 2018 and 2.1 per cent in 2019. If anything, they were too pessimistic about 2018, which now looks likely to be north of 3 per cent.
But slower growth in 2019 and ’20 has been expected among mainstream economic forecasters ever since the tax legislation took shape a year ago.
“Nothing in economics and markets happens in a straight line or without lags and feedback effects,” said Blu Putnam, chief economist at the CME Group. “There are some big headwinds all coming from events in 2018 that we know about, but whose impacts are yet to be fully felt or appreciated.”
And knowing something bad will probably happen is not the same as knowing when. It evidently took another confusing series of developments in economic diplomacy between the United States and China for it to become clear.
“Most economists are good at analyzing fundamentals, but they know better than to forecast direction and timing in the same sentence,” Mr. Putnam said.
Part of the agita on financial markets in the past few weeks has come from fears that the Fed has been underestimating these risks and is dead set on raising interest rates several more times next year even as the economy is still trying to adjust to the early rounds of increases.
Those fears have eased some as Fed officials have signalled open-mindedness and flexibility about the path ahead in the past few days. But a tricky period for the Fed is only beginning.
The optimistic case for 2019 is that a rebalancing of the economy is under way that will create both losers (interest-rate-sensitive industries and those that rely heavily on trade with China) and winners (everybody else).
The risk is that this hand-off doesn’t happen as smoothly as an economic textbook might predict. There are always frictions that can leave certain regions and certain workers in a bad spot for extended periods.
This episode, for example, could turn out to have similarities to what we’ve called the mini-recession of 2014 to ’16. The underlying causes are a bit different, but then, as now, prices of oil and agricultural commodities fell sharply, and makers of equipment that supply those industries saw plummeting business. It hit those sectors hard and dragged down overall growth, even if many people not in those industries didn’t notice it was happening.
The tricky thing for the Fed is that it must set its policies for the whole of the United States; it can’t set one interest rate for the service sector in big coastal cities and another for farm-equipment makers in Iowa.
With the unemployment rate at its lowest level since 1969 and average hourly earnings starting to rise a bit more rapidly, all the traditional signals point to continued interest-rate increases being justified.
So what markets have right is that this is shaping up to be a perilous time for the economy, in which bad luck or bad policy could easily create a major slowdown or recession. And that’s the case no matter how strong things look at the end of 2018 or how long it has taken markets to reckon with that reality.