In January of 2018, the Dow Jones Industrial Average was at 26149. Today, it is essentially at, or slightly below that level. During the 19 months since January 2018, the Dow has seen a low of 23327 in December 2018 and a high of 27359 in July 2019---a nearly 15% change. And, the risk of a nasty stock market correction continues. (Even after the down turn in August, the Dow is still more than 10% above December 2018.)
The problem stems from a gross misunderstanding of basic economics and history. Economists have known that increasing the money supply can stimulate economic demand. The important distinction here is the word "can" versus "will". Sometimes increasing the money supply (decreasing interest rates) does cause more borrowing and more consumption---assuming there is "pent up" demand that has been limited by higher interest rates AND limited by supply capacity.
So, IF economic activity has been limited by high interest rates and a limited supply, THEN lowering interest rates will cause borrowing for the purpose of increasing capacity.
But, what happens if central banks lower interest rates when supply capacity is so excessive that nobody increases capacity? The answer---people borrow money for purposes that do not increase economic activity---they borrow money to 1) speculate in financial assets; or 2) borrow money to simply rearrange the capital structure of their enterprise; or 3) borrow money for activities for which there is no demand.
Without an increase in the money supply thru lower interest rates (or other ways of printing money) a situation with excess capacity results in deflation--falling prices. Central banks fear deflation more than inflation, so they tend to err on the side of too much stimulus vs too little.
That is exactly what has been happening for years--but has accelerated since 2013. Speculation in financial assets has caused the Price/Earnings ratio of securities to increase. Corporations have borrowed money to buy back stock--reducing the number of shares outstanding resulting in higher Price/Earnings ratios of stocks. Governments have increased borrowing. Students have increased borrowing for education in areas where there is no demand.
And, lower interest rates do have a cost. When central banks lower interest rates, they reduce the income from savings. The loss of this income reduces economic activity dramatically.
Here is the text of my economic commentary mailed to clients this month:
Monetary Stimulus occurs when the money supply is
increased by the central bank. The central
bank lowers interest rates and generally this provides an incentive for
producers to borrow and invest, or for consumers to borrow and consume more. It
is the borrowing that increases the money supply. In addition, the central bank
can increase the money supply by literally depositing funds in banks thru a
process called quantitative easing. It has always been assumed that this monetary
stimulus is limited. Producers may not want to borrow and invest if there is
already too much productive capacity. And consumers may not wish to increase
their debt, or they are prevented from borrowing because they have reached
their credit limit. These limitations are illustrated by the metaphor: “The Fed
can’t push on a string”. So, increasing
the money supply may NOT actually stimulate the economy.
The other reason central banks increase the money supply
is to fight against deflation. Economists
fear deflation for two reasons. Falling prices tend to cause consumers to
postpone purchases in anticipation of getting a lower price later. This tends
to cause an economic slowdown. Secondly,
falling prices make borrowing much less attractive as debt becomes relatively
more expensive to repay—and debtors default. Expanding the money supply can create
inflation, even in a shrinking economy and central banks have dubiously decided
inflation is better than deflation.
Whether it is a need to stimulate the economy or
fight deflation---the underlying condition/s that create the need for stimulus is:
excess capacity; fear and uncertainty about the future, or both. In either case, monetary stimulus often does not expand the economy---producers
do not invest in productive projects and consumers don’t consume much more. Consumers
save instead of spend. What does happen is interest rates fall or stay low and
the price of monetary assets increase to reflect the lower rate of return on money. This is exactly what has been going on since
2013—all over the world. Corporations are borrowing more, but not to increase
capacity—rather just to buy back stock.
The only consumer borrowing that has increased significantly is student
loans—many of which will never be repaid in full.
Generally excess capacity is “cured” over a long
period. Older and/or less efficient operations are closed and eliminated. And, increasing population generally increases
demand. This can take a long time. Most of the excess capacity was built outside
of the US—that is why Europe and Japan are suffering the most. China is likely to experience even more pain
as they have increased capacity by historic proportions.
When does this situation change? One thing that can occur is that central banks
reverse the stimulus for whatever reason---most often because they sense an
expanding economy and fear inflation.
This in fact happened in 2018 causing a dramatic stock market correction
in November-December. Another is that the expanded money supply simply leads to rising
prices. People, especially businesses and governments simply become willing to
pay higher prices. Once prices begin to rise, interest rates tend to follow.
Of
course, instead of inflation and interest rates rising, there could be a sharp
economic slowdown—most likely from a pattern of debt defaults. With the central banks having already used up
their ability to stimulate---there is little that can be done to reverse the
resulting economic decline.
Given
that stock and bond prices are at historically high levels relative to their
earnings---either case: Inflation or Recession will probably lead to a substantial
decline in the price of many stocks and bonds.
Or, if not, there will be a very long period with historically low
returns on investments--economic stagnation like never before seen.
If your
investing horizon is less than 20 years, this high risk requires a careful
assessment of your personal tolerance for risk. The very definition of risk is
an uncertain outcome. The current situation has never existed before.
Bad may never happen. But, bad may happen and you must evaluate whether you
wish to reduce the negative consequences for your personal situation.
My personal
advice for most clients: Do not over-react, but you should be more conservative
in your investments with larger holdings of assets that do not fluctuate until
this current uncertainty diminishes. And be prepared for this period of
uncertainty to last longer than most people think. Be what is called a “Careful
and Prudent Investor”.
The future can never be predicted with absolute certainty. I highly recommend that you read my January 2018 post. I inferred that we are in a time like the 1920's. We are seeing all of the same kinds of "beggar thy neighbor" actions by governments around the world--increased tariffs and trade barriers, changes in currency valuations, arguments over trade and in China, the same kind of "totalitarian empire rising" issues that we saw in the late 1920's and throughout the 1930's with Japan and Germany. A crash like 1929 may not be in the cards---central banks are very unlikely to allow deflation--and it is highly unlikely there will be the type of military conflict we saw in WWII--but it is highly likely that we will be seeing a very uncomfortable and long period of "transition" as demand and supply return to a more balanced condition and we see the outcome or a more clear picture of China's military and economic rising.
And, since central banks tend to err on the side of inflation, it is very possible that central banks may allow inflation to rise more than expected. In that case, they are likely to react swiftly by raising rates which will slow down demand and likely cause stock markets to fall for a time.
(Keep in mind that when central banks stimulate by expanding the money supply--there is always inflation. In the latest round of stimulus, since 2009, the inflation has been in the price of stocks and bonds. What many fail to realize is that low interest rates mean that bond prices are "inflated". The inflation we saw in earlier periods was in good and services--consumption and hard assets like commodities, oil, copper, gold, art, collectibles, silver and real estate. The inflation we have seen since 2015 has been pretty much limited to financial assets like stocks and bonds. At some point, it is possible and even likely that "excess" holdings of stocks and bonds will be moved toward consumption and hard assets---the "old fashioned" inflation. This will likely result in dramatic drops in the prices of both stocks and bonds, with bonds no longer being the "safe" investment they have been historically.)
So, whatever occurs, be prepared for above average fluctuation in investment market prices during this transition period.
