Today, financial markets had a bit of an off day... Alright, maybe a rough stretch... Alright, so I guess calling it a rough stretch is a bit of an understatement. The Dow had its worst day today since we all thought the world was going to end in 2008, dropping 512 points (over 4%), and the index itself has dropped over 10% over the last 10 days (as has the S&P, which is a better measure of broader market attitudes than the Dow; and the Nasdaq). The first thing to note is that the stock market is a really terrible measure of the country's economic health. It dominates the news and the talking heads spend a lot of time on it, but, if anyone reads this, relax, the stock market is NOT in any way a measure of how the broader economy is doing. All a stock price reflects is people's attitudes about companies' future prospects. In other words, it's a lagging rather than a leading indicator, and it's often wrong: Paul Samuelson, pretty universally regarded as the greatest economist of the second half of the 20th century, famously noted that the stock market had predicted nine of the last five recessions. That was true, and also prescient. Sometimes, a dip in the market signals the start of a recession (the burst of the tech bubble in 1999/2000, the stock crash that sparked the Great Depression). Other times it follows a move back into recession. Other times, it doesn't mean much of anything at all (in 1987, the major global indices dropped over 20% in a single day, followed by... nothing; last May, the Dow lost 600 points in 5 minutes), besides that trading algorithms were selling off stocks rapidly. So there's no need to panic because the stock market had a crummy day.
What the lagging stock market recently DOES mean is that investors by and large aren't optimistic about the growth and profitability prospects of listed companies in the near future. And that has a lot to do with expectations centered around the lagging economy, and Congress and President Obama's inexplicable and inexcusable decision to ignore the job and growth crisis and focus on... the deficit. A major culprit here is the mainstream press. The first "expert" CNN quotes in the story I linked is Peter Schiff. Peter Schiff is an ignoramus. He's an expert in the economy in the same way I'm an expert at speaking Mandarin Chinese (one of my college friends taught me to say "Hello pretty girl", and spent the next hour making fun of me for speaking Chinese with a French accent). He has an eminent record of being wrong about everything. Schiff's incoherent claim is that the stock market tanked because now, all of a sudden, markets realized that "stimulus didn't work." He'd have you believe that traders woke up one morning in late July and decided, "Gee, that stimulus passed in 2009 really didn't get the job done; I'm selling NOW." If that sounds stupid to you, that's because it is.
In this case, though, the economy is certainly struggling, and markets clearly don't think the deficit reduction deal is going to do anything to stimulate growth (that much was obvious to anyone with a brain) or even address the deficit (as Herbert Hoover demonstrated). What we'll most likely end up with is possibly a shrinking nominal deficit (if Republicans get their way and gut everything), but a rising debt burden, as GDP craters (debt only matters as a proportion of GDP; to put it in practical terms, a person making $160,000 a year with $10,000 of debt has a much smaller debt burden than a person making $16,000 a year with $5,000 of debt). And the US's economy isn't the only one struggling; borrowing costs for Greece have long been skyrocketing, but the spread between Italy and Germany's 10-year rates is spiking. Now, at this point, I look like I'm being inconsistent: how can I say that it's bad that interest rates on 10-year Treasuries are low (3.125%), but it's also bad that interest rates on Italian bonds of the same maturity are high?
The answer to that is nuanced. For one thing, a yield by itself doesn't tell you much. Yield prices in inflation (if the real value of the currency it references is lower, the yield is higher), likelihood of repayment (if a country has a history of fiscal irresponsibility, yields on its debt are higher), and the broader state of the economy (if companies are doing well, investors are more likely to move money out of safe-haven government bonds (specifically, US Treasuries) and into riskier stocks and corporate bonds, which drives demand for Treasuries down, and thereby increases their yield.
So what's the story? Well, to anyone looking at it with a clear head, it's pretty straightforward. In the US, low stock prices reflect investor pessimism about the state of the economy and the recovery; they're moving their money out of stocks and corporate bonds and into what is still the ultimate safe haven investment (Congress's shenanigans aside): US Treasuries. Which explains why Treasury yields are so low. Those yields would be rising significantly if investors expected the hyperinflation Peter Schiff has spent the last 2 years hysterically railing about. Unfortunately for him, no one is and he comes across looking like the buffoon that he is (no one would take the 4% coupon on 30-year Treasuries that is currently being paid if they thought that hyperinflation was right around the corner). So in the US, we've got investors who are pessimistic about the recovery but believe that the government will continue to be good for the money it is lent, and won't inflate away its debts.
In Italy, coupons on debt are soaring, but stocks are down. If investors thought Italy was at risk of high inflation, that inflation would also be reflected in stock prices (explaining the mechanics of inflation will take another post, but basically if prices and wages are spiraling, stock prices will spiral, too). Very clearly, those same investors aren't bullish on Italy's recovery. Essentially, they're increasingly worried that Italy will default. This is made even more acute by the European Central Bank's obsession with inflation, which is driving it to raise rates even as its peripheral countries need looser monetary policy to help them address their massive debt overhangs. But, day by day, I think the Eurozone is coming apart at the seams (and Gillian Tett, my second-favorite English financial journalist, agrees), as the peripheral countries with big debt burdens are swamped by an inability to service their debt. I think the story will go something like this. Greece has literally no growth prospects in the medium- or even the long-term without a default. Their debt overhang is massive, the bailouts they're getting are essentially pushing payment on that debt overhang into the future in the hope that growth will somehow restart, but, without the ability to conduct expansionary monetary policy (since they're in the Euro) or expansionary fiscal policy (because they're locked out of capital markets), there's really no way to see Greece restarting growth. Eventually, the rest of the Eurozone will lose the political appetite to keep throwing money at Greece, and will decide to draw the line. At which point bond markets in the other peripheral economies will begin crumbling too. At that point, we have a repeat of the Lehman Brothers crisis, only way bigger.
Now, I'm not claiming that will definitively happen, but I think it's a semi-plausible scenario. And that kind of scenario being semi-plausible is a pretty scary prospect.
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