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Markets and Economy

What Caused the Stock Market Drop?

Last week’s sudden stock plunge opened the door to pessimistic predictions about the future of the expansion—with analysts blaming interest rate normalization, the deficit, trade tensions or global equity markets. But today’s strong macroeconomic fundamentals tell a different story.
Jim Glassman, Head Economist, Commercial Banking
October 17, 2018

The stock market plunged sharply last week, erasing $1.3 trillion of equity wealth from household portfolios over two days. In the aftermath of the market’s stumble, several theories have emerged to explain the sudden downturn, which interrupted a bull market that has consistently pushed valuations to new heights over the past nine years.

The true reasons behind last week’s decline may never be known. The stock market is inherently volatile—and is likely to become more so as the market climbs higher—and sporadic sell-offs aren’t unusual in bull markets. Sometimes the events triggering a stumble are obvious, but not always.

Most of the post-mortem explanations for the market’s slide are implausible because the fundamentals that drove the market’s long climb are still in full force. While the theories attempting to explain last week’s stumble cite real factors that are affecting the economy, none seems capable of suddenly reversing the market’s momentum.

Unlikely Theory No. 1: Climbing Interest Rates

Equities are influenced by interest rates. All things being equal, higher borrowing costs will negatively impact future earnings. When rates rise, the cost of servicing revolving credit climbs, cutting into businesses’ bottom lines. Higher bond yields can make capital investments more expensive, dampening growth as businesses forego debt-financed expansions.

But gradually rising rates did not suddenly cast a shadow over the stock market. The Federal Reserve began making incremental rate hikes almost three years ago, and futures markets have already priced in the trajectory of short-term rates toward 3 percent. Throughout the current bull market, equity investors have made their valuations knowing that borrowing costs would slowly rise. The ultimate target for short-term interest rates is only 1 percentage point ahead of inflation, which should hardly stifle capital investment.

Long-term interest rates have also risen, with the 10-year Treasury yield recently pushing to 3.15 percent. But like short-term interest rates, bond yields have evolved slowly, making them an unlikely source for stock market jitters. And the favorable developments that have been pushing yields higher—forces like deregulation, tax cuts and the energy sector’s revival—should support stronger future earnings, despite the slow rise in borrowing costs.

Unlikely Theory No. 2: Diverging Global Equity Markets

Until last week, the US stock market had resisted the slump affecting equities abroad. Some analysts theorize that last week’s stumble marked the start of an inevitable re-convergence of American and international equity valuations.

But American businesses have indeed had a better year than their counterparts abroad. US firms are enjoying strong domestic demand, and profits are being boosted by a massive fiscal stimulus package. Changes in the tax code should make US corporations more competitive globally, raising their potential future earnings. It’s neither surprising nor unsustainable for US stocks to outperform global indices this year.

Unlikely Theory No. 3: The Ballooning Federal Deficit

The federal deficit has widened considerably over the past year. The Treasury issued more than $1 trillion in new marketable debt over the past 12 months, up from $539 billion in 2017. Is the deteriorating fiscal outlook sowing doubts about future corporate earnings?

Eventually, the looming structural deficit could hurt growth. As the population ages, debt-financed entitlement spending is projected to claim an ever-larger share of the economy, potentially crowding out private investment.

But the current deficit is the result of a combination of rising federal spending and falling tax receipts, which is boosting corporate bottom lines by leaving more money in the private sector. If the recent tax legislation succeeds in accelerating growth, it will strengthen—not worsen—the nation’s long-term fiscal outlook.

Federal borrowing has yet to stress capital markets. Yields are not spiking, and the rate spread between public and corporate debt is at historically moderate levels. The widening deficit couldn’t have suddenly surprised markets—the nation’s fiscal position has been forecast with great accuracy, and there’s been no significant budgetary action in almost a year.

Unlikely Theory No. 4: Trade Tensions

Heated rhetoric between the US and China has led to $32 billion in new tariffs on imported Chinese goods. Tariffs are undoubtedly complicating the future for some businesses, but the conflict isn’t likely to alter the fundamental opportunities presented by China’s industrialization. Ultimately, the current round of tariffs may be more than offset by the devaluation of the yuan. Over the summer, the currency fell 10 percent against the dollar, which will eventually push the price of imported Chinese goods down by approximately $53 billion. Perhaps more importantly, this summer’s devaluation may be a sign that the Chinese government has decided to absorb the tariffs’ costs in order to minimize disruption to the economic order.

Keeping the Momentum

Several factors may have contributed to the market’s stumble, but the fundamental economic backdrop is extremely favorable for continued earnings growth. Stock valuations are a reflection of investors’ expectations, and the market should still be optimistic. The rise in corporate profits appears durable, full employment has arrived, inflation remains tame, and consumer spending has strengthened as household bottom lines improve. Despite last week’s stumble, the stock market has created $7 trillion in wealth since 2016. And with relatively few imbalances threatening the current expansion, the outlook remains bright.

View our economic commentary disclaimer.

 

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