The fear generated by Wall Street’s sharp fall in recent days had been greatly magnified by the calm that preceded it. Before the 8 percent decline in United States stocks over the past week — which was followed by a bounce back of nearly 2 percent on Tuesday — the S. & P. 500 had gone two years without suffering a drop that large. Spoiled by this unnaturally placid stretch, many Americans had forgotten what a routine market setback even looks like.
They better get used to this. In a typical year, according to data going back three decades, the market experiences a correction of about 10 percent. What Americans are witnessing now is thus a return to normal market behavior, which has never followed a straight line.
This year could be pivotal, because the conditions that underpinned the steady upward march of stock prices are now likely to deteriorate. In the United States and around the world, stocks have been buoyed by the trifecta of accelerating global growth, low inflation and loose central bank policies, all of which are now poised to turn against the bubbly market.
Optimists believe that the global economy this year can still grow 4 percent, the pace it maintained during the post-World War II miracle. But the miracle was driven mainly by the postwar baby boom, which ended years ago. Many investors have yet to internalize the fact that 4 percent growth is unrealistic. Fewer workers means slower economic growth and will make it difficult for the world economy to sustain even its 2017 pace of just over 3 percent growth.
Fewer workers also means labor shortages and higher inflation. Unemployment rates are close to a 40-year low in developed economies, including the United States. If the United States economy keeps adding 200,000 jobs per month, as it did in January, the unemployment rate could fall below 3.5 percent by the end of the year. And a rate that low has never been sustained in the past.
This looming shortage of workers is now putting upward pressure on wage growth, which has been steadily rising in recent months. And historically, wage growth has been a strong driver of inflation, as workers use their expanded paycheck to bid up prices for goods and services.
This then is the big picture: Over the past year, investors worldwide have been pleasantly surprised by an unusual combination of economic growth beating their expectations and inflation undershooting expectations. These pleasant surprises fed an unnatural calm. Over the coming year, these forces are likely to reverse, as labor shortages slow growth and begin to drive up inflation and bring a normal level of volatility back to the markets.
The scale and timing of a turn in the markets is likely to be decided by the third leg of the trifecta: easy money. Central banks have been printing money like never before, holding interest rates at record lows for extended stretches. Investors have used this cheap liquidity to drive up prices for everything from stocks and bonds to Bitcoin and fine art. The United States stock market is now around 25 percent higher than it would have been had it grown at its historic average pace.
Stock values have rarely risen so high, yet many seasoned investors had come to believe that these nosebleed valuations could be justified as long as the Federal Reserve Board kept interest rates low. When investors are worried about the future, they move money into cash, and today their cash balances are at record lows. In other words, complacency was arguably at a record high when the correction began last week.
Watching their market wealth soar, even average middle-class Americans got caught up in the faith that nothing could go wrong. They started spending aggressively again, after dialing back in the wake of the 2008 financial crisis. The United States savings rate has fallen to a mere 2.4 percent, from post-crisis peaks of well over 6 percent. Consumer credit card debt is rising. By some estimates, the confidence inspired by rising stock prices accounted for a third of the economic growth over the past two years.
In the past, whenever the stock market has been this expensive, an increase in interest rates has brought it back down to earth. In recent years, the swelling size of the stock market has magnified the potential economic impact of a correction. If the stock market suddenly reverts to its long-term trend, implying a fall of almost 25 percent, it could push the American economy close to recession.
All eyes are now on the central bank. Confidence that the idyllic economic conditions of the past year will last indefinitely has been rattled, particularly as wage growth begins to signal a return of inflation. Many investors are fretting that the Fed may be compelled to raise rates faster than anyone had expected, just the kind of negative surprise that could deflate sky-high prices in all assets, and not only for stocks. The year 2018 may be remembered as the time when the moody market beast returned to its natural state.
Source : LINK