Stocks stagger as end of party nears

Stocks have stumbled badly in recent days. A sharp sell-off late last week left the Dow Jones index in the red for the year. The S&P 500 posted its worst weekly fall in two years, a slide of 2.6%. The pan-European FTSE Eurofirst 300 index slid by almost 3% last week to a four-month low.

Markets have been able to shrug off a wide array of problems so far this year, says Randall Forsyth in Barron’s. These include China’s banking system; the Isis insurgency in Iraq; the Ukraine crisis and sanctions on Russia; and Gaza. “Excluded from this list is the latest default by Argentina since, like the Chicago Cubs, anybody can have a bad century.”

But all these issues now appear to have begun weighing on markets, while in Europe investors were also rattled by the deepening hole at Portugal’s Banco Espirito Santo, which the state bailed out early this week.

However, the main concern is that the end of the easy-money era is coming. Strong data this week suggested that interest rates could rise sooner than most people had imagined.

Markets have been “gorging” on cheap or free liquidity from printed cash or low interest rates for years now, says Allister Heath in The Daily Telegraph. But the party could be over soon. The US Federal Reserve is due to finish its money printing, or quantitative easing, programme, in October.

The markets had been pencilling a possible first rate hike in late 2015. But it’s looking as though “we are closer to lift-off than the market assumed we were”, says Fed member Richard Fisher. So uncertainty has crept into US monetary policy, which tends to dictate the tone for world markets.

American growth has rebounded

Last week it emerged that the American economy grew by an annualised 4% in the second quarter, rebounding strongly from a weather-induced dip in the January-March period. Meanwhile, a gauge of manufacturing activity rose to a three-year high, pointing to stronger domestic demand.

Dow Jones index chartThere was also more good news from the labour market: 209,000 new jobs were created in July, making it the sixth month in a row that payrolls grew by more than 200,000. That’s a streak not seen since 1997.

“When wage growth heats up,” says The Wall Street Journal, “the economy will have absorbed enough jobs to push inflation higher.” This could be starting to happen. Average hourly earnings are only rising at 2% a year, according to last week’s job figures.

But other gauges tell a different story. For instance, the Employment Cost index (ECI), which monitors wage and benefit costs for employers, jumped by 0.75% in the second quarter, the fastest rise since early 2008.

A recent analysis by JP Morgan suggests that the ECI has been the best indicator among wage and labour-cost measures when it comes to predicting where inflation is headed.

Coping with higher rates

Market history suggests that rising interest rates don’t usually cause too much problem for stocks, other than some initial wobbles, because dearer money is ultimately a sign of economic strength.

But this time round the amount of monetary loosening and money printing has been unprecedented, while debt loads have never been higher: in the developed world, total debt is worth 275% of GDP. So higher interest rates will be more of a burden than previously.

Given all this, the Fed and other central banks will be loath to tighten too soon in case the economy can’t cope. But the danger of waiting is that inflation could take off, necessitating potentially larger and faster hikes later – and squeezing the economy harder than they needed to in the first place.

Of course, they could time it beautifully, tempering inflation and allowing growth to continue. But since central banks “failed to anticipate the debt crisis of 2006-2008”, says Buttonwood in The Economist, “this is an attitude of the purest optimism”.


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