Despite the continued growth of the American economy, 2018 was not great for Wall Street, as the market closed the year on a major losing streak. Some have speculated that the primary cause of the stock market’s downturn is the Trump Administration’s current policies’ disruption of the natural flow of the world’s political scene. Others, such as Jim Cramer, have taken a different view, blaming the Federal Reserve’s policy and aggressive rhetoric [1]. However, these explanations are too simple, and function more as a political Rorschach test than an effective analysis of market conditions.
While 2018 was by all accounts a great year for the American economy, these gains failed to translate to the stock market for one fundamental reason: uncertainty stemming from the policies of previous administrations. Recent monetary policies pursued by the Federal Reserve like quantitative easing distorted market expectations, yet this economic history is discounted in favor of a revisionist narrative that exclusively blames the trade war and other recent occurrences for the stock market’s relatively poor performance. Instead of paying attention to the underlying fundamentals of the American economy, the prevailing explanations for the stock market’s behavior rely on sensationalism and ahistoricism; cable news treats the public to a steady diet of anti-Trump/pro-Trump rancor, leaving many investors confused and searching for answers. Troublingly, the relative stability of the labor market, low inflation and 3% growth for the first time in this decade mask a shockingly fragile economic ecosystem, one with significant consequences for Main Street and Wall Street alike.
For the past 10 years, investors have relied on the Fed’s Zero Interest Rate Policy (ZIRP), under which the Fed lowered interest rates to near zero. This policy is typically used by central banks when the economy is weak to induce investors and consumers to borrow and consume. The Great Recession in 2008 required such a policy, as the Fed lowered rates to nearly zero and kept them there for 7 years. However, the Fed worried this policy would not be enough to prevent a major liquidity crisis and began a policy of quantitative easing (QE). Under QE, the Fed began buying bonds or other assets like loans and mortgages from the private market to increase the money supply and introduce liquidity into a market. Often, the assets bought are so-called “toxic” assets that are hard for banks and corporations to get rid of. These worthless assets—useless securities, failed CDO’s, and underwater mortgages—were stuck on the balance sheets of the large financial institutions, reducing the market’s liquidity.
The combination of ZIRP and QE in response to the Great Recession improved the situation, but ZIRP and QE did not end with the recession; the Fed’s QE program ended in late 2014, and the Fed didn’t raise interest rates until December 2015. Markets feared a slowdown after 2014 with the end of these programs: ZIRP had allowed for cheap and easy borrowing and created a great environment for potential investors, who were more likely to take a risky investment with low interest rates than when they are higher, and QE created monetary liquidity in the financial markets and artificially lifted the prices of various financial assets in the market by way of supply and demand. The increase in borrowing and consumption due to both policies inflated the prices of all goods and assets in the market, increased money supply growth, and helped businesses via high stock valuations that gave them more capital to invest. The prospect of ending QE and ZIRP meant less money flowing into the stock and bonds markets, and reduced liquidity of assets, potentially slowing the recovery.
The economic results after QE ended in late 2014 were mixed. While job growth continued at a fair pace, GDP growth and inflation fell over the next two years as the stock market remained mostly neutral through 2015. The predicted slowdown did occur but was not as drastic as many feared it would be, causing confidence in the economy to grow. With this newfound confidence, the Fed believed the economy could withstand monetary tightening, and in December 2015, the Fed rose interest rates from 0.25% to 0.50%. The results of that rate hike were largely negative. A month after, the Fed had received significant backlash from spooked investors, as the DOW fell 1000 points off its high in early 2016, forcing the Fed to reassure investors that it would be risk averse in its monetary tightening policy. From this point on, any talk of rate hikes would be followed by a significant stock market decline.
In late 2016, the stock market climbed several thousand points because of the election of a perceived pro-growth president. The prospect of an administration who would pursue purportedly pro-growth policies fueled investors’ confidence in the markets. In response, the Fed—who themselves were still confident in the economy—began raising interest rates. This time the investors seemed indifferent to the Fed’s hike, and the Fed would raise continue to raise rates from 0.5% to 2.5% over the course of two years.
However, by 2018, the weariness of investors had returned. The effect of increased interest rates is lagging, affecting many indicators in the long-run rather than the short-run. Some of these have only recently materialized: increased mortgage rates have caused the number of potential home buyers to decline; interest rates on debt have begun to increase, causing investment in the stock market to slow; and most troublingly, the yield curve had briefly inverted. Each of these developments exerted downward pressure on the markets, as many investors recognized that the last time these indicators occurred concurrently was prior to the Great Recession.
Similar financial history in 1998 and 2005—years that saw strong growth before steep recessions—back up this possibility. Economic indicators in 2018 are similar to those of 1998: the labor market is as tight as the late 90’s, unemployment sits below 4%, and the economy saw strong manufacturing growth. In 2005, despite relatively sluggish growth in the United States, the world economy boomed as China, the EU and the developing world writ large drove global economic growth. This historical comparison provides two distinct possibilities for the future. If the Fed decides to accommodate for the slowing world economy, there might be a booming 2019 economy, or, if the Fed fails to do so, a 2019 where the economy enters its last hurrah, as the USA begins an economic slowdown and eventual fall into recession.
The ball is in Jerome Powell’s court, and the course the Fed takes will have significant effects in determining our nation’s immediate economic future. The path the Fed will take is yet to be seen, but one thing is for certain: the Fed has played a pivotal role in 2018’s stock market decline, and the market’s future is directly linked to the Fed’s monetary policies going forward.
[1] Gurdus, Lizzy. “Cramer Remix: In the Economic Blame Game, the Fed Is a Bigger Problem than Trump.” CNBC. December 19, 2018. Accessed March 01, 2019. https://www.cnbc.com/2018/12/18/cramer-remix-the-fed-is-a-bigger-economic-problem-than-trump.html.
Photo credit: Susan Walsh, © 2018, Associated Press
