Tipping points

Paul Krugman recently tweeted that he had no idea why the stock market had suddenly tanked, whether it would continue to decline or bounce back, and whether these developments would have any impact on the real economy. Granted, the second question is not easy to answer, but for the others, either the 2008 Nobel Laureate in Economics is being falsely modest or extremely ironic. US long-term rates rose sharply in early October, which brings to mind the sudden rise in early February. Upside surprises in terms of wages and inflation triggered February’s upturn, while the catalyst in early October was a strong rise in non-manufacturing ISM, an indicator that is usually not monitored very closely. That this indicator should have such a big impact already shows how nervous the markets are. The slump on Wall Street that triggered Paul Krugman’s tweets did not occur for another week thereafter, which is also very revealing, as if investors needed some time for the information to sink in. A rebound quickly followed. The increasing jitteriness of the markets seems to correspond to an end-of-cycle feeling, marked by doubts about a possible sudden upturn in inflation, and whether the period of strong US growth might not be coming to an end. There is something fascinating about worrying about two factors at the same time that a priori should not occur simultaneously. This reflects the high valuations both in the bond market, which is anticipating a less rapid tightening movement than the Federal Reserve is projecting, and in the equity market, which needs solid earnings growth to justify such high PE multiples. Without suggesting that history will necessarily repeat itself, we cannot help but draw a parallel with the months that preceded the 1990 recession, when an initial period of stronger-than-expected inflation, which drove the Fed to tighten monetary policy further, was followed by a second phase of increasingly disappointing growth figures.

To return to Krugman’s tweets, the financial market’s structurally higher volatility is bound to have an impact on the real sphere. Studies, notably by ECB staff and the Federal Reserve, have shown that it is an excellent leading indicator of economic activity. This might seem puzzling at first, since greater volatility is traditionally believed to reflect growing doubts about growth, which would seem to imply an instantaneous correlation. Observations in which greater volatility in the recent past (e.g. 24 months) has preceded an economic slowdown by several months or even quarters can be attributed to two factors. First, higher financing costs: high volatility is often accompanied by asset price trends (wider spreads between corporate and US Treasury yields, or an equity market decline). Second: households and companies tend to take a more cautious approach to spending and investment. High volatility erodes their confidence in their own forecasts, especially when long-term commitments are involved such as house purchases for households and investment projects for companies.

Of course, the effective growth rate of the US economy in the quarters ahead will depend on a whole set of factors and not just on recent equity market volatility. We must admit, however, that numerous factors argue in favour of a slowdown: the impact of this year’s budget and fiscal impulses will wane; this year’s dollar’s appreciation will slow exports; the rest of the world is already experiencing a slowdown; investment surveys are also signalling a slowdown; higher interest rates are beginning to strain residential real estate activity… not to forget the uncertainty surrounding the trade war and the impact of monetary tightening. Seen in this light we can understand why the yield curve is flattening: investors consider that economic data will provide the Federal Reserve with fewer arguments to continue tightening the screws. This is a support factor for the bond market, because it will prevent a major surge in long-term rates, while nonetheless pushing equity investors to focus even more on earnings growth. In the end, the tipping point that really matters is not between low inflation and more inflation, but rather between robust growth and insufficient growth.

This text was initially published in Agefi-Hebdo (France).