Making sense of the US stock market. Reason to worry?

Stockmarket palpitations are always great for low level headlines from daily media. The latest has been no exception with headlines screaming really dumb tags such as “Dow drop is a record”. It’s click bait in the extreme and a commentary on just how superficial coverage by popular media is.

On a percentage basis that daily on February 5th doesn’t even make the Top 50 of so-called “shocks”. It was a nothing. Even looking from its recent peak, the market is now down just 6.5%, hardly beyond the range of historic volatility of such swings. Anyway, it filled an otherwise vacuous few column inches in the Press for a few days.

The market has been on an extremely strong upswing over 2017 and so some sideways movement would hardly be a shock.

For the first time in years interest rates don’t look as though they’ll retreat to save this upswing. The economies are all going well – indeed the major ones are in sync – and so the obligation of the guardians of inflation is to ensure that it doesn’t get out of hand. Pre-emptive interest rate rises have been underway in the US since the end of 2015 (albeit from incredibly low Fed Funds rate of zero), and the Fed funds rate (their version of our OCR) is likely to get to 2% this year at least from the current 1.5%.

The relevance of this is whether it starts to make the earnings yields on stocks an inadequate return for risk. The current earnings yield on the S&P500 is around 4% pa, compared to a real interest rate of say 0.7% (that’s a US 10 year bond of nearly 3% less implied inflation expectations of 2.3%). So on the face of it a premium for equity risk of 3.3% is still adequate (it averages 2-4% historically). In other words equities are not over-valued.

But investors will worry that after such a long period of incredibly accommodative monetary policy, whether central banks will overdo the tightening and send the actual economy into a funk which clearly could lead to an earnings (profit) slump so that the return implied by the current historical PE of 25 (ie; 4%) is going to fall – and by inference the risk premium compress – meaning stocks are dear.

Nobody knows the answer, and markets, as markets do – it being their role – are searching for the right scenario to bet on (sorry, to price stocks on).

Now let’s talk about New Zealand’s positioning in this situation. We have historically high external debt ratios. Despite record prices for exports and record low for imports, despite the lowest interest rates seen for multiple decades, New Zealand has managed to saddle itself with big debts to foreigners. And it’s not the government that has done it – it is Mom and Pop who have borrowed like hell from trading banks and thrown it all at property to make ourselves rich. The trading banks don’t get their funds so much from Kiwis making deposits – they borrow them from abroad.

We wrote at length about our debt load back in April 2017.  In essence – like Spain and Ireland were – we are sitting ducks should global interest rates soar. And this right now is the question global financial markets are asking. Are the major economies sufficiently strong and near capacity, that continued growth will generate an outbreak of inflation? And if the central banks fear they might be, will they raise interest rates so quickly that a recession results? Such an outcome will hurt export-dependent economies like ours and of course that harm will be amplified if our external indebtedness drives our interest rates higher faster than elsewhere.

So when New Zealanders are bemused by the palpations of the US stock market, they’d be better to consider how resilient this place is to the scenario of rapidly rising interest rates that is concerning global investors now. And the answer is we are not. Moreover I’ve yet to see any economic strategy from the Ardern government that reduces that vulnerability.

Gareth Morgan

Gareth@top.org.nz


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