LONDON (Reuters) - The stock market is not the economy, and the economy is not the stock market, but they do sometimes move in unison and are becoming increasingly integrated. There’s a growing risk they could soon enter a self-feeding loop that drags them both lower.
“Doom loop” might be too strong - that’s more 2008 - so let’s call it a “gloom loop”.
The U.S. economic cycle and market bull run are already, or close to, the longest in history, so they are naturally more vulnerable to reversal. The danger is that they feed off each other, accelerating the downturn and magnifying the damage.
Falling U.S. equities tend to hit consumer sentiment, spending and business investment, and tighten financial conditions, not just domestically but globally.
With the economy probably peaking and the Fed showing few signs of slowing the pace of rate hikes, the economic damage could be significant.
The historical correlation between stock market and economic downturns is patchy, at best. If economists have a notoriously poor track record in predicting recessions, the stock market’s record is even worse.
Since 1929, U.S. stocks have suffered an average drawdown of 30 percent on 28 occasions, only 15 of which involved recessions, according to Dario Perkins at TS Lombard. Sometimes, like 1987, steep market declines don’t precede recession, while sometimes, like 2008, they do.
There have been peak-to-trough declines of at least 15 percent in 11 calendar years since 1980. Five coincided with recession, six did not, according to Perkins.
The market turmoil last month - “Shocktober” - saw the S&P 500 fall 7 percent, its worst month in seven years. Stock markets worldwide fell sharply, many of them in the emerging world entering or going deeper into bear market territory.
But investors held their nerve, and markets have rebounded nicely in the first week of November. Wall Street entered correction territory - registering a peak-to-trough decline of at least 10 percent - but a bear market remains some way off, for now.
The economic damage appears to have been minimal and so the Fed is keeping its cool too. It seems committed to its rate-raising path for the remainder of 2018 and beyond to at least what it considers neutral, around 3 percent.
Would another month like “red October” for markets force the Fed to change course? You’d think so, but not necessarily, says Steve Barrow at Standard Bank, noting that the economy is already beyond full employment so there’s no guarantee slower growth will reduce inflation.
Barrow argues that raising rates to cool inflation when growth is slowing is riskier than tightening when inflation is sub-target and growth is strong, which has mostly been the case in the Trump presidency so far.
The U.S. financial sector has a far bigger share of the economy than elsewhere in the developed world. According to the OECD, it accounts for nearly 10 percent of GDP - nearly double the share in the euro zone.
But because the global economy and financial system are more integrated than ever before, the fallout beyond U.S. borders could be significant. The OECD estimates that U.S., UK, Japanese and Canadian GDP would all fall by nearly 0.5 percent in the year following a 10 percent fall in U.S. stocks.
“Stronger financial market integration increases the adverse spillovers from the U.S. shock on output in all economies,” the OECD said.
The term “doom loop” may be over-used and too dramatic in this case. Instead, Gabriel Sterne at Oxford Economics says the global economy and markets are in a circular, “precarious loop”.
The market selloff in October had little effect on GDP. But if the growing number of risks - including downward revisions to U.S. earnings growth, central banks draining global liquidity, rising rates and higher dollar - puts asset markets under even greater pressure, GDP will suffer.
A 20 percent fall in global equity prices could reduce average GDP across developed economies by between 0.3 and 1.1 percent, and reduce global GDP by as much as 1.6 percent in a severe scenario, Sterne and his colleagues estimate.
If there is to be a U.S. recession, the consensus view among economists is that it will be in 2020, when Trump is expected to run for re-election. Another month or two on the markets like October, however, could easily hasten the downturn.
The opinions expressed here are those of the author, a columnist for Reuters.
(Editing by Mark Heinrich)