Ironically, stocks volatility could prolong the upswing

Last week’s mini stock market crash has renewed fears of an imminent end to the US upswing. In fact a weaker stock market could help prolong it. How? By contributing to a dialling back of consumer spending in an economy where the biggest threat is overheating and inflation. But there are geopolitical threats too behind stock market jitters. The biggest is the deteriorating relations between the US and China, but also last week the Saudi response to allegations over the murder of journalist Jamal Khashoggi raised fears of a new surge in oil prices. As I have argued before, the current tight state of the oil market due to the collapse of oil supplies from Venezuela is a major risk to the world economy.

Forecasting the stock market over the short term is impossible. Over the next few weeks, a further decline is as likely as a rebound. We would point out simply two things. First, stocks normally become more volatile in the Late Upswing phase of the business cycle, a phase that we have been in now for a couple of years. Second, stocks usually keep rising until the upswing is nearly over and in deep trouble, as in 2000 or 2007. As long as growth is solid investors keep climbing ‘the wall of worry’.

The major exception was in 1987 when the US market fell 33% within 3 weeks, mostly over a few days. But that followed a huge speculative run-up in the prior year and took the market only back to year-ago levels. At the close last Thursday the S&P500 was down almost 7% but already nearly back to its January 1 level (2673), underlining that, despite bears’ fears, and worries about overvaluation, we don’t have the same exuberance today that we saw in 1987.

So, leaving aside the geopolitics for a moment, is the US economic upswing still solid? The data has been very strong. Both the 3 and 6 months change in the Conference Board’s Leading indicator are buoyant suggesting no imminent pullback. You could certainly argue that the best of the 2017-18 growth surge is over, as the effect of tax cuts subsides, but there seems no reason to think the economy will slump next year. A pull-back to growth of around 2%, in line with many forecasts, seems about right.

Which brings me back to the key issue, the threat of overheating. It is not happening yet and may not happen for a couple more years at least, given the sluggish response of wages so far. But it is usually overheating, (combined with higher oil prices which is partly a result of overheating), and the Fed’s response, which kills upswings. The ‘trend’ growth rate in the US is only around 1.5-2%, based on labor force and productivity growth. So recent GDP growth of around 3% is unsustainable without eventually stoking higher wages and inflation.

Both the Fed and the bond market are increasingly focussed on this risk. Yields on US 10 year TIPs (inflation indexed bonds) have risen above 1% for the first time since 2011, (see chart) signalling that it is a rise in real bond yields which pushed the conventional Treasury yield above 3% in recent weeks. That means the bond market is anticipating a tougher approach from the Fed.

Central bankers take a much longer-term view of these things than the markets. Unemployment at 3.7%, busting through the low of 3.9% in November 2000 and taking it to the lowest rate since 1969 is worrying the Fed. Even the U-6 measure of unemployment, which includes people discouraged from working or working part-time, is back to levels below those of 2007. In short, the labour market is tight today on any measure.

But are higher bond yields bad for stocks? Well, not necessarily. First, historically, bond yields have usually tracked upwards in the Late Upswing stage of the cycle, but so have stocks. Secondly, theoretically, if bond yields are rising because inflation expectations are rising then profits growth should be higher too, so the effects net out. But, as I just said, it is real bond yields that are rising today so, in theory, that does impact stocks. It says that investors can earn more in completely safe investments, making stocks less attractive. That said, its only a small move so far.

And crucially a less buoyant stock market could actually help prolong the upswing, by dampening the economy slightly. Consumer wealth effects from lower stocks tend to be mild and spread over time so they can dampen the economy without creating a major break. Most stockholders are well off anyway and they don’t need to change their spending habits much given a moderate change in stock prices (lets say up to a 20% decline). The only real danger is if business dramatically changes its investment plans. But it would take a lot more than a pull-back in the stock market, even up to a 20% decline, given the gains of recent years, to bring a big change here.

Let’s come back to the geopolitics for a moment. The murder of Saudi journalist Khashoggi, apparently inside the Saudi Embassy in Turkey, shocked the world. But both President Trump and the Saudi government are now trying to defuse the political implications so the threat that the Saudis would deliberately hold back oil supplies in angry defiance, pushing prices above $100 has receded.

But that still leaves the big story of our time: the US switch to outright hostility towards China. VP Mike Pence’s speech on October 4th at the Hudson Institute, spells out that the US government has declared a ‘cold war’ against China. While some of this should doubtless be seen as electioneering, there is little doubt that the US government, as a whole, is more anti-China than ever before. The risk of a miscalculation (over Taiwan or the South China Sea) leading to a hot conflict is still very low. But we already have trade tariffs and there is also the potential for sanctions to be used at some point. By creating uncertainty over the future of international supply chains, these threats can delay investment plans.

Still, again, barring any sudden steep rise in tensions, anything which effects a modest slowdown in US growth will tend to prolong the US economic upswing if anything. The same goes for any further economic weakness in China or Europe. In summary, don’t worry that a moderate pull-back in the US stock market will, on its own, cause a recession. If we do see a major decline it won’t be the decline itself which does for the upswing, it will be whatever triggers it, whether that is geopolitics, oil or the Fed.