Stock market trouble ahead?

Should stock market investors lose money next year, they will not be able to say they were not warned by the world’s main central banks.

First, Federal Reserve Chair Jerome Powell has been warning that bringing down inflation might require a prolonged period of high interest rates and below trend economic growth. Now, both the Fed and the European Central Bank are warning of heightened risks to the world financial system.

Indeed, in the words of the Fed’s recent Financial Stability Report, “the rapid synchronous global monetary policy tightening, along with surging inflation, the ongoing war in Ukraine and other risks, could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage.”

Stock markets seem to go through periods of forgetting that long-run stock market prices are determined both by the expected stream of company earnings and by the interest rate at which those earnings are discounted. The lower the expected earnings stream, the lower will be the long run stock market price. The lower the interest rate, the higher will be the stock price for any given earnings stream.

Today, we seem to be going through one of those periods in which the stock market is largely focused on the interest rate outlook and is mostly forgetting about the earnings outlook. In staging its impressive 10 percent rally from its September 2022 low, the stock market is increasingly expecting that as the inflation data improve, the Fed will pivot away from its present monetary policy hawkishness. If the Fed does indeed pivot, interest rates next year will be lower than they would otherwise have been.

To be sure, if earnings were to hold up, a Fed pivot would be good for stock market prices in that it would lead to lower interest rates at which company earnings would be discounted. However, a very different story would emerge if the reason for the Fed’s pivot was the prospect of a meaningful economic recession or a world financial crisis. In those circumstances, the downgrading of earnings prospects would likely swamp any benefit to stock prices from lower interest rates.

Jerome Powell has been clear in his determination to keep interest rates sufficiently high for as long as needed to reduce inflation from its present 7.7 percent level to the Fed’s 2 percent inflation target. As former Treasury Secretary Larry Summers never tires of reminding us, it is highly implausible that such a large reduction in inflation can be achieved without producing a meaningful economic recession.

The bond market seems to be grasping the great likelihood of a recession next year by sending short-term interest rates significantly above longer-term interest rates. By contrast, stock market analysts seem to be ignoring that likelihood by barely downgrading their earnings forecast.

Making the stock market’s current complacency all the more difficult to understand are the Fed and ECB’s explicit warnings of heightened world financial market risk at a time of synchronous monetary policy tightening, high inflation and geopolitical tensions. The market’s seeming complacency is more difficult to understand considering the many cracks that are already emerging in the world’s financial system.

Over the past year, China’s Evergrande, with $300 billion in debt, and 20 other Chinese property developers have defaulted on their loans. In the United Kingdom, last month the Bank of England had to bail out the UK pension system with a $65 billion intervention in the UK gilt market to save it from ill-advised derivative positions. Meanwhile in the emerging market space, Argentina, Russia, Sri Lanka and Zambia have all defaulted on their debt. More recently, the cryptocurrency market has been shaken by the run on FTX, a cryptocurrency trading platform.

Maybe this time around, we will be lucky and markets will continue to rally despite a recession and despite any financial market crisis. However, if the pessimists prove to be wrong in calling for real stock market trouble ahead, they could defend themselves by saying that all the clues and historical experience were pointing in the opposite direction.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.