If stock market investors lose money next year, they won’t be able to say that the world’s central banks didn’t warn them.
First, Federal Reserve Chairman Jerome Powell warned that reducing inflation may require a long period of high interest rates and lower economic growth. Both the Fed and the European Central Bank are now warning of growing risks to the global financial system.
Indeed, according to the Fed’s recent Financial Stability Report, “the rapid synchronicity of global monetary policy, coupled with rising inflation, the ongoing war in Ukraine and other risks, could lead to increased vulnerability, for example, due to tightening liquidity in markets.” financial principal or hidden leverage.
Stock markets seem to go through periods of forgetting that stock market prices are determined both by a company’s expected stream of earnings and by the interest rate at which those earnings are discounted. The lower the expected income stream, the lower the stock market price will be. The lower the interest rate, the higher the stock price for each income stream.
Today, we seem to be going through one of those periods where the stock market is mostly focused on the interest rate outlook and largely forgets about the earnings outlook. With the stock market showing an impressive 10 percent return from its September 2022 low, it is increasingly expected that the Fed will move away from its current monetary policy stance as inflation data improves. If the Fed actually moves, interest rates will be lower next year than they would otherwise be.
To be sure, if earnings are maintained, a Fed hike will be good for stock market prices, as it will lead to lower interest rates, where corporate earnings will be discounted. However, a very different story emerges if the reason for the Fed’s move is the prospect of a significant economic downturn or global financial crisis. Under these circumstances, a downgrade in the earnings outlook is likely to dampen any gains in share prices from low interest rates.
Jerome Powell was clear in his decision to keep interest rates on hold for as long as necessary to reduce inflation from the current 7.7 percent to the Fed’s 2 percent inflation target. As former Treasury Secretary Larry Summers never tires of reminding us, it is highly unlikely that such a large reduction in inflation can be achieved without producing a significant economic recession.
The bond market appears to be underestimating the possibility of a recession next year by sending short-term interest rates significantly higher than long-term interest rates. In contrast, stock market analysts seem to be discounting this possibility, slightly lowering their earnings forecasts.
Underlying the current stock market lull are clear warnings from the Fed and the ECB about rising global financial market risk at a time of simultaneous tightening of monetary policy, inflation and geopolitical tensions. The seeming calm of the market is more difficult to understand given the many cracks that have already appeared in the world’s financial system.
Over the past year, the Chinese company Evergrande, which has a debt of 300 billion dollars, and 20 other Chinese companies failed to pay their debts. In the UK, last month the Bank of England was forced to bail out the British pension system with a $65 billion intervention in the British gold market to save it from unwanted derivatives positions. Meanwhile, in the emerging market space, Argentina, Russia, Sri Lanka and Zambia have all defaulted on their debt. Recently, the cryptocurrency market has been shaken by the work of FTX, a cryptocurrency trading platform.
Maybe this time we will be lucky and the markets will rally despite the recession and regardless of any financial market crisis. However, if pessimists are mistaken in calling out real problems in the stock market, they can defend themselves by saying that all the signs 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 Economic Strategist for Emerging Markets at Salomon Smith Barney.