Stock market problems ahead?

Stock market problems ahead?

If stock market investors lost 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 reducing inflation may require a prolonged period of high interest rates and below-trend economic growth. Today, the Fed and the European Central Bank warn of heightened risks to the global financial system.

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

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

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

Certainly, if earnings were to hold, a Fed pivot would be good for stock prices as it would lead to lower interest rates at which corporate 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. Under these circumstances, the downward revision to the earnings outlook would likely negate 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 level of 7.7% to the Fed’s inflation target of 2%. As former Treasury Secretary Larry Summers never tires of reminding us, it is highly unlikely that such a significant reduction in inflation could be achieved without producing a significant economic recession.

The bond market seems to be seizing on the strong probability of a recession next year by sending short-term interest rates well above longer-term interest rates. On the other hand, stock analysts seem to ignore this probability by barely lowering their earnings forecasts.

Explicit warnings from the Fed and ECB of heightened risk in global financial markets at a time of simultaneous monetary tightening, high inflation and geopolitical tensions make the current complacency in the stock market all the more difficult to understand. The apparent complacency of the market is harder to fathom given the many cracks already appearing in the global 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 UK, last month the Bank of England had to bail out the UK pension system with a $65 billion intervention in the UK gilt market to save it from misguided derivative positions. Meanwhile, in the emerging market space, Argentina, Russia, Sri Lanka and Zambia have all defaulted on their debt. More recently, the cryptocurrency market has been rocked by the run on FTX, a cryptocurrency trading platform.

Maybe this time around we will be lucky and the markets will continue to recover despite a recession and despite any crisis in the financial markets. However, if the pessimists were wrong in announcing real stock market problems, they could defend themselves by saying that all the indices and historical experience point in the opposite direction.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.

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