Financial markets are very unsettled. Since this time last year, credit spreads in the bond market have gapped out, the value of the U.S. dollar has surged, and oil and other commodity prices have tumbled. Most disconcerting have been the wild swings in the stock market, which has suffered its worst start to any year on record. There is increasingly ominous talk that the troubled financial markets are signaling, or may even precipitate, a recession. Deep dive: Headed for recession?
While the turmoil in financial markets will do some damage to the economy -- Moody's Analytics has lowered its forecast for real GDP growth this year by half a percentage point to 2.3% -- the recession talk is off-base. Indeed, the economy is creating lots of jobs across all pay scales, and the remaining slack in the labor market is being quickly absorbed. The economy remains firmly on track to reach full employment by midyear. Deep dive: U.S. employment situation.
Financial markets have suffered a series of wrenching spasms over the past year-and-a-half. The selloff has been especially hard in the market for below-investment-grade or high-yield corporate bonds. The yield spread between high-yield corporates and 10-year Treasury yields is approaching 800 basis points.
This is more than double the spread that prevailed in summer 2014, when markets were calm.
The value of the U.S. dollar also has soared. The real broad trade-weighted dollar is up a stunning nearly 20% since summer 2014 and is as strong as it has been since the early 2000s. The dollar is up against nearly all currencies, but most notably against the U.S.'s largest trading partners, including Canada, Mexico, Europe and Japan.
Of course, oil prices have cratered during this period, free-falling from over $100 per barrel to near $30 recently. Other energy and commodity prices have also slumped. Copper prices, which are often a good barometer of global economic conditions, are currently trading near $2 per pound, down from $3.25 in summer 2014.
Most disconcerting perhaps has been the violent step-down in stock prices. As measured by the S&P 500 index, stock prices are down more than 10% from their all-time peak reached last May. Some $2 trillion in stock wealth has evaporated.
Oil Price Bottom
Financial markets will stabilize only when oil prices do. The plunge in oil prices is the proximate catalyst for the selloff in markets, as the previously high-flying stocks and bonds of energy companies have cratered. The low oil and other commodity prices have also hobbled many emerging economies that U.S. multinationals and their shareholders had thought would power their long-term growth.
Driving oil prices lower has been Saudi Arabia's surprise decision to increase its oil production rather than offset the surge in production in U.S. shale fields. The world is awash in oil since the Saudis have calculated that while lower oil prices will be uncomfortable for them, they will be unbearable for higher-cost oil producers in the rest of the world, including in the U.S.
Global energy companies have been naturally reluctant to cut production, hoping that prices would rebound, but their day of reckoning is at hand. Prices are well below the long-run cost of production in many parts of the world.
Many energy companies borrowed too much in the good times and are running out of cash needed to make their debt payments. Bankruptcies, mergers and acquisitions are in the offing, and production cuts should soon follow. This should be the basis for more stable oil prices and financial markets later this spring. Deep dive: Is Saudi Arabia Planning for Lower Oil Prices?
China Holds Firm
Nervous investors will also calm down once it is clear that China's economy is holding firm. China is the second largest economy on the planet, after ours, and more importantly, many U.S. multinationals had previously sold their investors on the idea that China would propel their long-term growth. If China underperforms, so too will those companies and their stock prices.
It is reasonable to question whether China's economy will be able to throttle back gracefully, but the almost hysterical pronouncements of China's economic demise are overdone. China has its problems and is surely overstating its growth rate, yet it is still growing strongly and has enormous financial resources. More than $3.2 trillion in reserves at last count, which can be used to stimulate the economy, which Chinese authorities are very willing to do, or defend the value of the Chinese currency.
China is not Thailand circa 1998, when global investors fled that country, crushing the Thai baht, and igniting the Asian financial crisis. Asian companies that had levered up on dollar-denominated debt were forced to default, resulting in a debilitating recession. Capital flows to and from China have opened up in recent years, but only modestly, and could be easily shut down if the outflows became a problem. Chinese authorities have significant control over their economy and financial system, making a hard landing in China unlikely, at least any time soon. Deep dive: China's economy.
Fed Goes Slow
Investors also have agita over the Federal Reserve's decision to begin raising interest rates. It is common for financial markets to struggle when the Fed normalizes interest rates during economic recoveries. Investors are even more on edge this go around, as the Fed is exiting from the emergency policies it implemented in response to the financial crisis. Short-term rates had been effectively set at zero since late 2008.
But the Fed has shown significant sensitivity to financial market conditions. The decision to begin raising rates was ostensibly delayed from last September to December due to a previous bout of selling in markets. We also now expect the next rate hike to be delayed until June to give markets a chance to find a bottom. Investors will learn that the Fed means what it says, namely that it will take several years to normalize rates. Deep dive: FOMC's monetary policy.
Assessing the Damage
Even if financial markets settle soon as anticipated, the turmoil in markets has already harmed the economy. Gauging the degree of harm is extraordinarily complicated given the myriad channels through which financial conditions impact the economy.
The clearest damage is the impact the stronger dollar is having on U.S. trade. Struggling emerging market economies, hurt by weaker oil and commodity prices, are crimping exports. Weaker stock prices and the resulting loss of wealth weigh on consumer spending via the negative wealth effects. Lower stock prices and higher credit spreads increase businesses' cost of capital and thus impede investment and hiring. And then there is the dark pall all of this puts on consumer and business sentiment and the willingness to spend and invest. Deep dive: U.S. trade.
There are some positive cross-currents. While the lower oil prices are devastating for the energy industry, they are more-or-less good for the rest of the economy. The U.S. economy still consumes more oil than it produces. So, if the price of oil goes down, the economy ultimately wins. Mortgage rates have also declined as scared investors have piled into risk-free Treasury and mortgage securities.
Based on simulations of the Moody's Analytics macro model, which accounts for much of this complexity, the financial market turmoil will slice approximately half a percentage point from 2016 real GDP growth. This is under the assumption that oil and stock prices are near a bottom, that credit spreads are at an apex, and that while the dollar will appreciate further, the pace of appreciation will slow considerably. Deep dive: Why Wealth Matters.
Tighter financial conditions will slow the expansion, but there is little prospect that the tighter conditions will result in a recession, as a growing chorus seems to fear. It brings to mind the quip by the late Economics Nobel Laureate Paul Samuelson that, "Wall Street indexes predicted nine out of the last five recessions."
Indeed, of the 20 market corrections -- peak-to-trough declines of 10% or more -- in the past half century, only six were followed by recessions.
Recessions are always preceded by big declines in stock prices, as investors sniff out weakening sales and profits at big publicly traded companies. But investors are a fickle bunch and will sell for lots of reasons that may or may not be linked to what is going on in the broader economy.
None of the other tried-and-true signals of impending recession are even flashing yellow. Unemployment insurance claims remain extraordinarily low, the unemployment rate is falling and not rising as it does prior to recessions, and consumer confidence remains resilient. The shape of the Treasury yield curve also remains firmly positive; recessions have always been preceded by inversions with long-term rates falling below short rates. Deep dive: Headed for recession?
A Broader Context
The selloff in financial markets should also be put into a broader context. Not more than a year ago there was substantial handwringing that the stock, bond and other asset markets were overvalued, or perhaps even worse, in a bubble. Fed Chair Janet Yellen ruminated publicly that many high-flying biotechnology stocks were turning speculative. It was unheard of for a Fed official to make such a pronouncement, and signaled her discomfit that a bubble could be forming, which, if it burst, might ignite another financial crisis and recession.
The recent decline in financial markets is thus in many respects therapeutic. Any froth in these markets has been wrung out. Of course, this won't be comforting until financial markets find a true bottom.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.