So as we all dig ourselves out from the snow on the East Coast, the S&P is sliding again. There’s no sign of hibernation from the bears. In fact, there seems to be an unusual amount of pessimism and angst out there among professional investors, and wider unease among the public which shows up in support for populist or socialist candidates in the Presidential race.
So how much should we worry? Is it time to plunge our head in a snowdrift and hope for the best? Let’s take the positive view first, and then go to the dark side.
So far the stock market slide is nothing out of the ordinary, of course, uncomfortable and morale-deflating as it is. We usually get a 10% correction in equity prices every two years or so, based on the historical record. So far it’s a bear cub, rather than a raging grizzly.
Let’s say it gets worse from here. 20% corrections are more lumpy in when they occur, but the long term average is they hit every 3 1/2 years or so. That’s a definite scrape from the bear, but not life-threatening. And we’re still very far away from that.
50% or more plunges, like 2008, are extremely rare, far out the tail of the probability distribution, occurring every generation. Or two. Or three. But because we have painful memories of the most recent collapse, press stories about “worse than 2008” sell newspapers right now. Everything looks dangerous, but just like major earthquakes or hurricanes, it is likely to be decades before another hits us.
Putting this together, the most likely outcome, just in bare statistical terms, is a kind of regression to the mean and therefore recovery rather than another 2008-style catastrophe. That happens much more often in situations like this than a further slide to doom.
The trouble is frequency statistics can mislead. What if something more fundamental is broken? What if there’s cumulative damage? There are always plenty of “This time it’s different” arguments for potential disaster when markets are weak.
So what is different right now? What is so deep-seated and cumulative it could put us in 50% territory?
The main cause of recent market weakness appears to be the slide in oil prices, as well as concerns about a slowdown in China with knock-on effects on commodity producers. Add to those multiple pressures on emerging markets the recent Fed rate rise, which may have disproportionate impact on the outer fringes of the dollar zone.
Yet oil and commodity price swings are anything but unusual. A decline in oil prices is bad for the energy sector but good for just about everyone else in the major western economies. The same applies to a first Fed rate rise in a cycle, even if it does tend to upset markets.
And it isn’t at all clear yet that China really has had a ‘hard landing’, as opposed to volatility on its equity markets. Many people have lost their shirts predicting collapse in the Chinese economy over the last ten or fifteen years.
There is clearly a massive debt hangover, and massive surplus capacity. Let’s affirm it: China has plenty of problems. But it could be a chronic gradual headache for years, rather than a spectacular meltdown which causes the whole world economy to crash. Or a painful temporary interlude, like the many spectacular crashes as the US nonetheless rose to the pinnacle of the world economy between 1865 and 1914.
The same applies to tension in the Middle East. There is obviously a heightened chance of serious conflict, as low oil prices cut budgets and the Saudis are increasingly fretful about Iranian resurgence. But that too could be a chronic, slow-moving problem rather than an immediate hot war. Sunni-Shia tensions date back to before 680AD, after all. This is not unprecedented or unusual territory. “Trouble in the Middle East” is barely even news these days. And if a ship does get sunk or riots break out in a smaller Gulf state, oil is likely to spike – offsetting other worries.
None of this is likely to derail the US economy. It’s compatible with a rotation in economic activity from emerging markets towards the US, rather than a collapse in the world economy. On this story, the US with its relatively minimal exposure to foreign weakness takes over its usual role as the ‘locomotive’ pulling much of the rest of the world economy. Safe-haven capital flows to the US, interest rates rise as the Fed normalizes, the dollar accordingly rises giving a boost to exporters in other countries, and the locomotive is on its way.
Sure enough, there are some reasons to doubt that it is happening just yet – American consumers may be saving some of the dollars they are not spending at the gas pump, or driving more miles than before. But there is no reason to despair, or disbelieve altogether than the US is not going to gain significant impetus from lower energy prices before long.
There are other reasons many people worry about western economies, most notably rising inequality and technological threats to labor. There may be hidden bubbles after all the monetary liquidity we’ve had washing around. I’ll look at those another time – but there’s no reason to think that markets have suddenly become much more concerned about these explanations since New Year’s Day.
The deeper, different problem
Instead, the most interesting possibility is markets are concerned at a deeper level about what we can call the ammunition argument. Let’s say any of these potential threats materializes. We don’t have to predict which one, or time it to the day. Then what?
The US recovery is still fragile. The EU is beset by problems of its own making. The central banks are already at or extremely near the zero lower bound for conventional policy. Fiscal policy is more constrained by the massive buildup of debt from the last major collapse. There is much more suspicion (especially in the US Congress) about bank rescues or lender-of-last resort functions, including more legal chains on Fed actions in a crisis.
So if something does go wrong – the Fed misjudges the strength of the recovery and raises rates too much, say, a Chinese credit crisis leads to emerging market commodity disasters which cause strains in European banks who have lent too much money to middle-income countries – there is no ammunition in the locker.
If we take out the rifle to defend ourselves agains the charging bear, we’ll just hear a muted empty “click” and the bear’s jaws will close on our throat. Unlike any other potential crisis in the last hundred years, we’re defenseless.
On this argument, no-one can really predict the stock market (or the Middle East). It’s not a matter of predicting specific outcomes. But if anything goes wrong, we’re bear food. Talk to Murphy about his law.
And then? This is the deeper fear. Policymakers can’t do anything. They may stage a few theatrics, write “bang” on a piece of paper and wave it at the bear, perhaps. And whatever they do, they’ll likely mess it up. (They’ll probably misspell “bang”). It’s also linked to wider suspicions that elites don’t know what they’re doing.
This ammunition argument is the really important question, and deserves more consideration in the next post. It’s probably not true, but it’s a serious argument.