Föhrenbergkreis Finanzwirtschaft

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Markets’ Panic Incongruent With Economic Reality—For Now

Posted by hkarner - 21. Januar 2016

Date: 21-01-2016
Source: The Wall Street Journal

Stock selloff could presage recession (unlikely), trigger a recession (unlikely) or indicate a lack of faith in policy makers (plausible)

Financial markets are in a panic over a sharp economic downturn that has yet to make an appearance—and may never.

Many of the world’s biggest stock markets, including the U.K.’s and Japan’s, are now in bear-market territory, that is off 20% or more from their peak. With its 1.6% slump yesterday, the Dow Jones Industrial Average is down 9.5% on the year.

Yet if there’s no sign of similar stress in the broader economy, why pay attention to the financial indexes that, as the old joke goes, have predicted 9 out of the past 5 recessions? There are three possible reasons the market selloff could be cause for concern.

The first is that a recession is coming but has yet to show up in the data. The U.S. seems due: its economic expansion is now the fourth-longest since World War II, and the stock market is a leading, albeit error-prone, recession indicator.

But hard economic data is not behaving in pre-recessionary fashion. While U.S. growth was probably near zero in the last quarter of 2015, employment growth actually accelerated. Consumer sentiment rose in early January despite anxieties about stocks. Housing typically leads the economy into a downturn, yet the number of permits issued to build single-family homes actually rose in December.

What about the rest of the world? “A collapse of growth in China would…be a world-changing event,” Olivier Blanchard, former chief economist of the International Monetary Fund, recently noted. “But there is just no evidence of such a collapse.”

True, China’s growth last year fell to a 25-year low of 6.9%, but that’s the rate the government had long targeted. December imports and export data suggest China is in fact stabilizing.

Market Economy disconnectSurveys of purchasing managers from around the world compiled by J.P. Morgan Chase and Markit show that overall economic activity slowed a bit in December but to a level consistent with normal, long-term trend growth.

A multiyear slump in commodity prices and related exports has set back manufacturing in the U.S. and overseas. But oil prices have cratered, less because of declining demand—in fact, Chinese consumption is still growing—than a glut of supply. U.S. shale producers haven’t cut back as much as Saudi Arabia expected when it ramped up output in 2014, and Iranian exports are about to surge now that sanctions are being lifted.

The price collapse has in turn hammered energy investment, and that could be a potential drag. But Torsten Slok, an economist at Deutsche Bank, notes it has fallen from more than 10% of total capital spending to around 5%. That means it can’t fall much further.

The second possibility is that rather than economic weakness triggering financial panic, the panic itself produces a crisis or recession. The collapse in oil prices, for example, has caused yields on corporate bonds issued by both energy and nonenergy companies to jump, and many banks have reported big loan losses to energy companies. The spread between interest rates on super-safe Treasury bills and slightly less safe offshore three-month interbank dollar loans, known as the “TED spread,” a gauge of financial stress, has jumped.

On the other hand, banks have little exposure to energy compared with their exposure to subprime mortgages in 2008 or Latin American debt in 1982. And regulators have forced them to thicken their capital and liquidity buffers since the last crisis.

The third and most plausible possibility is that markets are losing confidence in policy makers, driven in particular by events in China and the U.S.

Chinese leaders fumbled in their efforts to stop their stock bubble from deflating and confused the world when they devalued the yuan last August and again this month. Chinese monetary policy is opaque and politicized, which means outsiders are skeptical of the official story that the devaluations are part of a move to a more market-determined exchange rate.

“We collectively lost faith in ability of the Chinese authorities to always do the right thing,” says Angel Ubide, a former hedge-fund manager now at the Peterson Institute for International Economics.

By contrast, the Federal Reserve is transparent and independent. The problem is markets disagree with its plans. Last December, it announced that with unemployment down to 5%, the economy no longer needed the support of near-zero interest rates and began to raise them, with the intention of lifting the short-term rate to more than 2% by the end of next year.

The stock selloff gathered steam Wednesday as worries about the state of the global economy grew among investors.

But the plunge in oil prices has put the Fed’s 2% inflation target even further out of reach, which, markets believe, merits even slower rate normalization.

The Fed’s determination (so far) to tighten means it is now a headwind for the stock market rather than the tailwind it has been with its multiple rounds of stimulus since 2008.

This isn’t necessarily a problem for the economy. In a recent client note Stephen Jen, who runs the currency advisory SLJ Macro Partners, challenged the idea that a stock selloff could only be justified by economic weakness. “We could turn the question around and ask if the U.S. and global economies have really improved by 200% since 2008, or by 20% since the peak of 2007?”

If the Fed is no longer encouraging investors to embrace risk, then stock valuations, such as price-to-earnings ratios, should decline. That’s unpleasant for stockholders, but largely irrelevant to the economy.

A bigger worry is that if recession or crisis do loom, central banks and governments can’t, or won’t, help. China’s leaders ?have ruled out opening the taps for another government-backed investment and lending boom?, which they think went too far the last time?. The Fed has only a quarter percentage point of interest-rate cut ammunition, and other central banks have none.

Andrew Balls, an executive at fund manager Pacific Investment Management Co., says markets should turn around when they are cheap enough, or when they anticipate some sort of “circuit breaker” like a central-bank rate cut. “I’m worried about the lack of central-bank circuit breakers.”

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