Opinion | How long will the Wall Street party last?
The withdrawal of policy accommodation is perhaps the biggest risk for the stock market
The S&P 500 has not seen a major correction since February 2009, and the ongoing bull run on Wall Street is said to have become the longest ever. Though analysts and commentators are quibbling about things such as the starting point of the bull run and intraday levels, the rally has surprised everyone. No one would have imagined in 2009 that a decade after the worst financial crisis since the Great Depression, analysts would be debating such technicalities. The S&P 500 has gained more than four-fold since February 2009, and the big question on Wall Street now is: how long will the party last?
Several visible risks have emerged which could affect the future trajectory of the market. Stocks in the US have rallied on the back of unprecedented infusion of liquidity into the financial system by the US Federal Reserve through quantitative easing. Besides, interest rates were kept close to zero for much of the past decade. The policy accommodation also helped recovery in real activity. But it is now being reversed.
The US Fed is not only raising rates but is also reducing the size of its balance sheet. The withdrawal of policy accommodation is perhaps the biggest risk for the stock market. Speaking at the annual central banking symposium last week at Jackson Hole, Wyoming, Fed chairman Jerome Powell indicated that interest rates will continue to rise. Moreover, the US economy is growing at a strong pace with unemployment near a 20-year low and may warrant more tightening than is being currently anticipated. The minutes of the last Fed meeting showed that the rate-setting committee is contemplating a change in the policy statement, which describes the stance as accommodative.
The withdrawal of policy accommodation along with the higher issuance of government bonds to fund the budget deficit would further tighten financial conditions. It has been reported that the appetite for US treasuries is reducing among foreign investors. This could push bond yields, which will affect the outlook for stocks. However, interest rates are not the only problem for the stock market. As Powell noted in his speech, excesses in the run-up to the previous two recessions appeared mainly in financial markets. Former Reserve Bank of India (RBI) governor Raghuram Rajan has also highlighted the build-up of leverage and asset prices, as happened before the last financial crisis.
Accommodative monetary policy in the US and other industrial economies pushed debt levels and asset prices in various parts of the world, including emerging market (EM) economies. Therefore, a reversal could be painful. The ongoing Turkish lira crisis is a case in point. In the US, the cyclically adjusted price-to-earnings ratio for the S&P 500 is running over 30, compared to the historical mean of 16.8, indicating that the market is overvalued.
Further, the trade war could get ugly. This, along with the build-up of leverage and asset prices, as Rajan highlighted in an interview last week, could become a toxic mix for the global economy. Growing internal political risk in the US could also affect stock prices significantly. US President Donald Trump has himself said that markets would crash if he were to be removed from office. So there is plenty to be worried about that has not been factored into stock prices.
Stock markets in India are also trading near all-time highs, but risks at this stage are more global than local. Analysts are expecting a pick-up in corporate earnings. A recent research report by Morgan Stanley, for instance, noted: “India’s growth is likely accelerating relative to EM. Our work shows that corporate confidence is at a multi-year high and profits are likely to mean revert from below trend…India’s corporate profit share in GDP is at close to all-time lows which means the upcycle could be quite significant—a contrast to most other parts of the world.”
A study of 1,462 listed companies by this newspaper showed that, after adjusting for one-time gains and losses, net profit at the aggregate level went up by 22.24% in the first quarter of the fiscal. An increase in economic activity and higher capacity utilization should help improve profitability in coming quarters. Higher stock prices have pushed valuations compared to historical levels and, therefore, continued earnings recovery will be important for the market. Indian markets also have benefited from the surge in retail participation through systematic investment plans of mutual funds. This has become a big stabilizing factor for the market.
Although it’s never easy to forecast a Lehman-like crisis, higher interest rates, deleveraging and tighter financial condition along with rising trade tensions are clear risks for Wall Street. These risks could also affect global growth and capital flows to emerging market economies.
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