Blame for the dramatic fall in international stock markets in the last week of February has widely been pinned on the COVID-19 outbreak. However, the likelihood of a stock market crash was in place well before the virus emerged.
During the trading week of February 24–28, the United States stock market dropped 12%. It was the worst week for the stock market since the 2007–08 Global Financial Crisis (GFC). Most other international stock markets fell similarly, with the Australian market falling about 10%.
Prior to the recent slump, the Dow Jones Index had experienced a 276% rise over its 2009 low during the GFC. Factoring out the impact of the GFC and comparing it to its 2007 pre-GFC high, it had risen 114%.
By comparison, the most recent US GDP figure shows a rise of 51% and 49%, respectively, over the same periods. This indicates the stock market is, at least, only very loosely connected to movements in the real economy and has been hugely over-inflated.
It also indicates that there is plenty of potential for much larger falls.
Australia’s ASX200 Index has doubled since its GFC low, although it has only surpassed its pre-GFC high in recent months. Meanwhile, Australia’s GDP has grown by a little more than half since the GFC.
Since the GFC, governments and central banks around the world have been trying to revive stock markets and encourage economic growth. Central banks have reduced interest rates to near zero or, bizarrely, lower than zero.
Buying bad debt
The US Federal Reserve’s main recovery effort has been its quantitative easing program, in which central banks buy government bonds or financial assets. But it has cast a wide net, including giving cash to financial institutions to replace the toxic mortgage-backed securities that triggered the GFC: a public bail-out of bad debt on a grand scale.
While it was projected that the cash and low-interest credit would stimulate the economy, the outcome has been only sluggish growth. On the other hand, it has been successful in stimulating stock markets, which have set repeated records.
When, in 2013, the Federal Reserve announced the “tapering” of its quantitative easing program, expecting markets to play their much-trumpeted role of managing the economy on their own, stock markets took a dive. The Federal Reserve soon reversed its decision.
Trump’s 2017 $1.5 trillion tax cuts, largely for corporations and the wealthy, were promoted on the basis they would stimulate the economy to such a degree that the extra tax revenue resulting from economic growth would more than offset the amount of tax revenue being given away.
While the US economy and jobs did grow following the tax cuts, there was no major uptick, certainly nowhere near enough growth for the US government to replace lost revenue.
Following the tax cuts, company share buybacks hit a record $1.1 trillion in 2018. In the first half of that year, companies spent more on share buybacks than on capital investment, so the big winner was the stock market rather than the real economy.
Ideologues of the market claim the market acts as an invisible hand that manages the economy perfectly. When things go wrong, they almost inevitably go looking for a cause external to the market to explain it.
Focusing attention on COVID-19 fits the bill.
The meteoric rise of stock markets, vastly outstripping actual economic growth, was never likely to be sustained.
Had the virus not come along, there would have been some other trigger. If the stock markets recover from this slump then a reckoning will simply be put off to await some other trigger.
Real growth illusive
If little of the stimulus that inflated the stock market has filtered down into real economic growth, less still has filtered down to working people.
The wages share of the US economy, which has been on the slide since about 1970, fell sharply during the GFC. After recovering part of that fall by 2015, it has declined moderately since.
Australia’s wages share has followed a similar downward trend since the 1970s and experienced a sharp drop during the GFC. While it recovered from the GFC drop by 2015, it then went through another sharp drop. The lack of wages growth has now become a talking point among business circles, bemoaning the fall in retail sales growth this has caused.
Unlike the US, Australia’s unemployment rate only briefly dropped below 5% before rising again.
Also unlike the US, the Australian government has obsessed about bringing the budget into surplus above all else. Thus, it has so far resisted calls, even from the Reserve Bank, to stimulate the economy through public spending, leaving it in the doldrums even compared to the less-than-impressive performance of the US economy.
Although the underlying cause of the fall in the stock market is its over-inflation relative to the real economy rather than COVID-19, this does not mean that fears about the impact the new coronavirus on the economy are unfounded.
In China, factories are shutting down due to the virus. In February, the official purchasing managers’ index (PMI) fell from an already low 50.0 in January to 35.7 in February for manufacturing, and from 54.1 to 29.6 in non-manufacturing.
The PMI is an indicator of purchasing managers’ expectations for expansion or contraction in business. Below 50 represents a contraction.
This suggests the rapid growth of the Chinese economy is likely to decline or even go into recession. Even without the spread of the virus, this will impact on the global economy, particularly China’s major trading partners, such as Australia (China takes a record 40% of Australia’s exports).
In the event of a resulting global economic decline or recession, however, COVID-19 will only be partly to blame.
A global slow-down or recession was already likely: PMIs in the US, Europe and Japan have been regularly dipping below 50 points for some time. The US composite PMI fell below 50 for the first time since the survey began in 2014, falling from 53.3 in January to 49.6 in February. Japan’s manufacturing index fell from 48.8 to 47.6
Australia’s PMI dropped to 48.3 in February, but had already dropped below 50 in October, before the COVID-19 outbreak, and also before the peak New Year bushfire emergency.
Last year, the US Treasury securities yield curve became inverted. That means the yield on short-term US government treasury securities became higher than that on long-term treasuries. An inverted yield curve has strongly correlated with a recession taking place within a year.
In the event of a downturn, the situation has the potential to become much worse given the level of global debt, which was a major factor in the GFC. The low or negative interest rates that central banks have adopted to recover from the GFC have fuelled more borrowing since the GFC.
The Bank of International Settlements' statistics on total credit to the private non-financial sector was at 158% of GDP at the time of the GFC in 2009. It dropped to 139% in 2011 but has since climbed again to 153%. In many major economies it has exceeded its pre-GFC levels.
In a February 28 statement, US Federal Reserve Chair Jerome Powell said in response to the new coronavirus outbreak: “We will use our tools and act as appropriate to support the economy”.
Likewise, Australia’s Reserve Bank brought forward anticipated interest rate cuts, cutting the cash rate to 0.50% on March 3.
This may, however, amount to trying to swim upstream and, like other central banks’ efforts, have more effect in rescuing stock market investors than anyone else.