Why the gloom?

A primer on the current market chaos and why we shouldn’t panic just yet.

The mood in financial markets has gotten a lot darker, from doom and gloom to pre-apocalyptic. There is talk of a U.S. recession, a global recession, a new global financial crisis comparable to 2007–08.

But the next financial crisis isn’t just around the corner — yet. Here is my take on what led us to the current chaos and why the real economy is stronger than it looks.

Financial markets have dissociated from the real economy in a very extreme way. It is important to understand why.

The real economy has indeed shown some weakening. China has slowed, and the pace at which foreign exchange reserves are declining could soon pose a challenge. In the U.S., the non-manufacturing sector has lost some steam.

These moves are not threateningly large, but they are in the wrong direction. They justify vigilance and some concern.

But the biggest sources of pressure on financial markets are coming from outside the real economy. Especially in Europe, tighter regulations make it a lot harder for banks to make money, reducing liquidity and curbing their ability to act as market makers. This makes investors more cautious, which reduces liquidity even more. The result is more volatility, and more concern.

The fall in commodity prices has also inflicted some pain, especially in stock markets. Companies exposed to commodities and global trade have a bigger weight in stock indices than in the overall economy — so when they’re vulnerable, stock price moves are too. But this doesn’t reflect the overall performance of the economy.

Finally, I think investors sense that after years of quantitative easing and zero interest rates, something is not quite right. This unprecedented experiment in monetary policy has created dislocations in financial markets. We can identify some — like the much bigger role that central banks play in government bonds markets. There might be others we have not seen. This adds to the uncertainty and anxiety.

But the real economy is still strong.

Three components together are keeping global growth on an even keel; not particularly strong, but nowhere near a global recession.

1. The U.S. labor market remains in rude health — confirmed by all the latest data. Today 4.3 million more people are working than before the recession. At the current pace of job creation, the unemployment rate would be as low as 4–4 ½ % by the end of the year. Wages seem to be picking up. As a result, consumer confidence remains robust and consumer spending strong, in the face of the stock market correction. With a strong labor market and strong consumption, a U.S. recession remains a very remote possibility.
2. I have written about China in a previous post, and my view has not changed. While growth in China has slowed, it remains resilient, and policymakers have plenty of dry powder to stimulate the economy if needed.
3. Europe is still doing ok: set to grow at about 1.5% for the second year in a row, supported by expansionary monetary policy and a more competitive Euro.

Today 4.3 million people more are employed in the US than before the Great Recession.

So although financial market pessimism is real and its growing, it is out of line with the fundamentals.

Still, the question remains…

Can the pessimism in financial markets become self-fulfilling?

I can imagine a scenario where further sharp drops in stock prices cripple consumer and business confidence, pushing firms to stop hiring and consumers to stop spending. This would confirm investors’ fears and trigger a new round of sell-offs in stocks.

A confidence crisis of this kind is a risk. But it is still unlikely, for two connected reasons:

• The labor market/consumption nexus in the U.S. feels so strong that it would take a very large correction in financial markets to knock it off course.
• Regulations have curbed leverage in financial markets to a very significant extent, making such a large correction less likely. Not impossible, but much, much less likely than ten years ago.

My expectation is that the global economy will hold up, fears of recession will fade, and financial markets will regain their footing. We have seen periodic waves of doom and gloom over the past five years, and all eventually receded. The risks of an adverse scenario are somewhat bigger now than they have in some time, but I believe the hard-working common sense of the real economy will again prevail over the paralyzed anxiety of markets.

Yet I am concerned by what seems to be an increasing paradox in the policy response. We know exactly what measures are needed to create higher growth:

• More jobs and higher wages in most countries.
• Greater spending on infrastructure.
• Simpler and leaner regulations.
• Lower taxes.

We know how these measures would work, and most experts agree they would be the most effective strategy. But there is little or no action on that front.

Instead, central banks are pushed to experiment with ever more creative solutions: first quantitative easing, now negative interest rates. These measures are relatively untested, they are becoming less effective, and we have a much shakier understanding of their side effects.

Sometimes the road less traveled is not the smartest choice.