After Two Weeks of Market Turmoil, What’s Changed? Not Much – Real Time Economics

Economic indicators that typically pick up the first signs of trouble, such as first-time claims for unemployment insurance, are steady or improving. 
CHARLIE RIEDEL/ASSOCIATED PRESS

A wild, two-week ride in the markets has left some investors poorer and nerves in tatters. Other than that, what have we learned?

First: The U.S. economy is fine, emerging markets are not, and the rest of the world is somewhere in between. Those trends were evident two weeks ago; they now have an exclamation point after them.

Secondly, the Federal Reserve’s job is getting harder. The arguments both for and against raising interest rates have become stronger, creating tension and uncertainty that is rattling markets.

It’s easy to conflate market events with economic events; a 1,000-point drop in the Dow Jones Industrial Average will grab anyone’s attention. Yet stock market corrections of 10% or more are, traditionally, routine.

Why might such a correction be cause for greater alarm? By aggregating information from thousands of companies, the market may be telling us something new about the health of the economy. Also, market movements can themselves generate economic distress by destroying wealth or interfering with companies’ or households’ ability to raise funds.

By those criteria, it’s hard to conclude the stock-market drop heralds a serious economic slowdown or recession. Economic indicators that typically pick up the first signs of trouble, such as first-time claims for unemployment insurance, are steady or improving. Globally, purchasing managers in both services and manufacturing have reported continued growth in new orders in recent weeks, according to surveys compiled by Markit.

At the market’s bottom, $2 trillion in wealth had been wiped from household balance sheets. That sounds like a lot, but in percentage terms, it isn’t. Household spending doesn’t react strongly to such moves precisely because they are so common. According to J.P. Morgan, it would trim 0.25 percentage points off the growth of consumer spending over each of the next two years, roughly equal to the expected boost from lower gasoline prices.

Could the market turmoil itself trip up the economy? VIX—the stock market’s fear gauge, derived from the prices of stock options—has spiked. But the sorts of insidious problems at the core of the financial system, such as those that capsized the economy in 2007-08, are largely absent. An index of financial stress compiled by the Federal Reserve Bank of St. Louis, which melds stock market indicators with a range of others covering bond and money markets, has ticked up but remains below normal. (One trouble spot to watch: problems pricing and trading exchange-traded funds, a major channel for both stock and bond strategies.)

What about the rest of the world? China’s economy is slowing, and probably by more than the official 7% growth rate indicates. But alternative measures, such as industrial production, exaggerate the slowdown because China’s economy is shifting to services, which are more labor intensive. That’s one reason why the job market seems unperturbed (although Chinese job data are spotty).

The deflation of China’s stock bubble should have no more economic impact than its inflation did. Gavekal Dragonomics, a China-based economic advisory, notes that shares comprise just 5% of Chinese household wealth. Share issuance is not a significant funding source for Chinese companies. Property prices are far more important to household wealth and as collateral for bank loans. House prices and sales have actually rebounded recently because of lower interest rates and fewer restrictions on purchases.

The decision by the People’s Bank of China to devalue the yuan is a net negative for the rest of the world since it will grab exports from countries that compete with China. But at 3% to date, it is not a game-changer.

So why did it cause so much turmoil? Largely because outsiders were divided on whether the move was, as the PBOC claimed, a genuine effort to align the currency with market forces, or a panicked response by Chinese political leaders to an economy slowing more quickly than they realized.

It may be both, but Chinese policy making is so opaque that no one can be sure. China, says Gavekal, is “pursuing an opportunistic agenda driven largely by nationalist political considerations….This means that Chinese policy decisions are becoming less predictable, and that the potential for conflict between political goals and economic fundamentals is increasing.”

One group of countries—commodity-dependent emerging markets—has seen the outlook worsen as a consequence of recent market events.

The writing has long been on the wall. An epic boom in commodity prices has been unraveling since 2011. But they are not falling solely because of lessening demand from China, but also because of rising supply, especially of oil, by producers. Thus, rather than a net negative for the world, the latest downdraft should be seen as a negative for commodity exporters such as Russia and Canada and a positive for importers such as India and the United States.

So while there is little reason to think the global economy is about to run aground, the recent turmoil exposes some fragilities. The most important relates to what the Federal Reserve will do next. All year, Fed officials have signaled they would like to raise interest rates from near zero, where they have been since 2008, perhaps as soon as September. Unemployment is down to 5.3%, close to what’s considered normal, which makes it harder to justify abnormal rates.

Recent data strengthens the case. Economic growth in the second quarter was revised up to 3.7% at an annual rate, leaving the first half at 2.1%, far better than earlier estimates. Reports on retail sales, housing and the job market are relatively upbeat, as are anecdotal reports from companies.

The problem is that inflation, already below the Fed’s 2% target, is slipping further way. The Commerce Department said inflation, excluding food and energy, was 1.2% in July. The recent drop in oil and rise in the dollar could nudge it lower.

Historically, when the Fed raised rates, investors took comfort that it was confirmation of an accelerating economy that bolsters profits. And if the economy reversed course, so could the Fed.

This time, the economy is not accelerating, and since the economic expansion is six years old, it is not about to. And in the remote event that a few rate increases trigger market chaos and set back growth, neither the Fed, nor its global counterparts, are well equipped to respond.

The European Central Bank has already cut interest rates below zero and is buying bonds (“quantitative easing”). China has room to cut interest rates and bolster government borrowing, but that would worsen the problems of excessive debt left over from its previous stimulus. Other emerging market central banks worry that steep rate cuts could fan the inflationary effects of cheaper currencies.

To use an overworked analogy: The world’s firefighters are short of water. It’s not a problem now; it will be should the world economy catch fire.

Related reading:

For Emerging Markets, 2015 Isn’t 1997

Why Currencies in Emerging and Advanced Economies Now Act More Alike

For All Its Heft, China’s Economy Is a Black Box

Economic Risk of Stock Plunge Varies Around Globe

 


 


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28 August 2015 | 8:24 pm – Source: blogs.wsj.com

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