Stock market trouble ahead? | The Hill

If stock market investors lose money next year, they won’t be able to say they weren’t warned by the world’s main central banks.

First, Federal Reserve Chairman Jerome Powell has been warning that long periods of high interest rates to reduce inflation and the trend could slow economic growth. Now, both the Fed and the European Central Bank are warning of heightened risks to the global financial system.

In fact, in the words of the Fed’s recent Financial Stability Report, “Rapid simultaneous global monetary policy tightening, along with rising inflation, the ongoing war in Ukraine and other risks, could amplify vulnerabilities, for example due to stressed liquidity. Key financial markets or hidden leverage.”

Stock markets seem to have gone through periods of forgetting that long-term stock market prices are determined both by a company’s expected stream of earnings and the interest rate at which those earnings are discounted. The lower the expected income stream, the lower the long-term stock market value. The lower the interest rate, the higher the stock price for any income stream.

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Today, we seem to be going through one of those periods in which the stock market is largely focused on the interest rate outlook and often forgets the earnings outlook. With its impressive 10 percent rally from its September 2022 low, the stock market is expecting the Fed to move away from its current monetary policy stance, as inflation data improves. If the Fed does indeed pivot, interest rates next year will be lower than they would otherwise be.

To be sure, if earnings were to hold, a Fed pivot would be good for stock market prices because it would lead to lower interest rates that would be discounted over company earnings. However, a very different story would emerge if the reason for the Fed’s pivot was a meaningful economic downturn or the possibility of a global financial crisis. In such circumstances, a downgrading of earnings prospects can offset any gains in stock prices from low interest rates.

Jerome Powell has been clear about his determination to keep interest rates high enough for as long as necessary to reduce inflation from the current level of 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 implausible that such a large reduction in inflation could be achieved without producing a meaningful economic recession.

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The bond market appears to be embracing the greater possibility of a recession next year by sending short-term interest rates above long-term interest rates. In contrast, stock market analysts seem to be ignoring that possibility by downgrading their earnings forecasts.

The Fed and ECB’s clear warnings of increased global financial market risk at a time of synchronous monetary policy tightening, high inflation and geopolitical tensions are making the stock market’s current complacency more difficult to understand. Market complacency is even more difficult to understand given the many cracks that have appeared in the world’s financial system.

In the past year, China’s Evergrande, with $300 billion in debt, and 20 other Chinese property developers have defaulted on their loans. In the United Kingdom, 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 an ill-advised derivative position. In the emerging market sector, Argentina, Russia, Sri Lanka and Zambia have defaulted on their debt. Recently, the cryptocurrency market has been rocked by a run on FTX, a cryptocurrency trading platform.

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Maybe this time, we’ll be lucky and the markets will continue to rally despite the downturn and any financial market crisis. But, if the pessimists are proven wrong in calling out a real stock market problem, 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 Emerging Markets Economic Strategist at Salomon Smith Barney.

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