The Great January Market Sell-Off Is Not Irrational


Many prominent economists seem to be scratching their heads over the recent bout of market turbulence. The consensus is captured crisply by Capital Economics: “The plunge in global stock markets does not seem to be justified by economic developments.” On the other hand, market participants and other non-academic observers are wondering whether this correction will turn into a bear market before the month is out; if it hasn’t already.

The Policy Tensor is usually more sympathetic to rigorous economists than seat-of-the-pants market observers and traders. But in this case, the economists are demonstrating their professional blinders. It is entirely possible to for a market correction to be justified without a fundamental slowdown in the domestic macroeconomy. And this is indeed what is going on.

The US stock market is not a claim on US GDP; it is a claim on US corporate profits. Profit growth can slow without a slowdown in output growth. The profits of US firms have been falling largely due to the strength of the US dollar. Continued policy divergence among the hard currency issuing central banks imply further dollar strength, thus lowering expectations of US profits in the medium term.

Moreover, while exports are only 13.5% of US GDP, the rest of the world contributes half the profits of US firms. Similarly, 97% of employment growth is now taking place in the nontradable sector, whereas the tradable sector accounts for half the growth in gross value added. So, one can have a robust and tightening labor market while profits margins get squeezed due to global disinflation and a rising dollar.

Indeed, as I have argued before, the US economy is much less resistant to an imported disinflation than an imported recession. In particular, this means that the profits of US firms are much less sheltered against global disinflation than the US economy as a whole is to recessionary headwinds from abroad. Therefore, the impact of adverse global developments on the US stock market is bound to be much more serious than on the domestic economy.

Finally, there are purely market developments that have implications for asset prices independent of the real economy. In particular, innovations in systematic volatility imply asset price adjustments regardless of what happens to GDP and inflation.

So what does the market know in January that it did not in December?

First, China: Policymakers in Beijing are clearly floundering and their ability to stem the panic is increasingly coming into question. The renminbi is depreciating faster than anticipated. Capital outflows from China are accelerating to such an extent that the $3.3 trillion cushion — down from $4 trillion — no longer seems invincible. An astonishing trillion dollars of capital has already left the mainland. Meanwhile, the industrial sector is doing even worse than expected.

Second, instead of stabilizing, the commodities rout has exacerbated. This has worsened the outlook for commodity exporters. Moreover, the continued price declines indicate a greater slowdown in global trade and output than previously recognized. To put it bluntly, the world is doing much worse than was realized in the benign aftermath of the Fed’s liftoff; a decision that looks increasingly ill-judged.

Third, it is now being realized that the banks are much more exposed to the oil rout than was assumed to be the case. All the big banks have reported substantial losses on their loan books to the sector. It is clear that these losses will mount since the price of crude is likely to be depressed in the medium term. But it is not clear by how much and that is obviously very worrying given the central role played by financial intermediaries in powering economic growth.

Fourth, market participants can be more confident that market turbulence is likely to persist. The end of the repression of systematic volatility by the Fed and the reduced liquidity due to tighter regulation of broker-dealers increases the likelihood of market turbulence. This means that risk premia will rise since investors must be compensated for greater volatility, in turn implying lower asset prices. In other words: Even if asset prices were aligned with fundamentals before and assuming that said fundamentals haven’t changed, asset prices would still need to fall to reflect the repricing of risk.

So, yes, even though expectations for US GDP and inflation have barely changed since the December meeting, the market correction is warranted.

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