Shine Trader Limited Live reports:
Recently, the U.S. stock market has seen a significant correction due to increased expectations of Fed tapering and the impact of the debt ceiling, but if history is any guide, the U.S. stock market may not be in a true correction period. The real corrections in U.S. stocks come during recessions when the output gap is about to fall: 1990, 2000, 2007. In 2018, the US has been at the end of the economic cycle, and the VOLATILITY of the US stock market has increased. In 2019, the Federal Reserve’s precautionary interest rate cut lengthened the economic cycle. But the economic cycle is inevitable, and even without the pandemic, a decline in the US output gap would have come soon enough.
The decline of output gap means that the growth rate of output is lower than the growth rate of potential output, the economy enters a state of contraction, and the ROE of enterprises will also start to decline. If the growth rate of output only falls, and is higher than the potential growth rate of output, the economy is still expanding and the output gap will continue to widen. At this point, although the growth rate of corporate earnings declines, the growth rate is still high, the ROE continues to rise, and the growth rate of stock prices will decline, but it is still positive growth. Only when the output growth rate is lower than the potential output growth rate, the profit growth rate is lower than a certain threshold, and the ROE is about to decline, will the stock price growth rate be lower than 0, and the stock price begin to decline.
The timing of share price adjustments is also reflected in interest rates. When the output gap turns positive, monetary policy tends to start to tighten, and a period of rising interest rates is followed by more restraint on the economy. The marginal return to capital is decreasing, the cost of financing is increasing, the economic cycle is downward, and the growth rate of output is declining and lower than the growth rate of potential output. As a rule of thumb, near the peak in interest rates, stock prices begin to undergo a true correction.
So when will the U.S. stock market enter the real adjustment period? That is, when does the US economy start to contract and the output gap and interest rates on US debt fall?
Although the ISM manufacturing PMI and Market manufacturing PMI began to decline from April and August respectively, they are still relatively high. The economic growth rate is higher than the potential economic growth rate, the economy is still expanding, the negative output gap continues to narrow, and it is expected that the output gap will turn positive by the end of 2021. This round of monetary policy normalization is both faster and slower than after the subprime crisis. Faster than after the subprime crisis means that the shadow interest rate began to rise before the post-epidemic monetary easing reached its maximum level after the subprime crisis. Slower than after the subprime crisis is to say that the output gap after the subprime crisis has reached the current stage of monetary policy has begun to raise interest rates, and currently only talk about tapering. Of course, this does not mean that the current monetary policy normalization process is slow or fast, because the path of natural interest rate changes under each crisis is different, and the reasonable trend of monetary policy interest rate should not be the same path.
The economic cycle is asymmetric. The output gap is negative and rises for a long time, but when it turns positive, it may immediately decline and turn negative. This is the economic cycle proposed by Friedman in the Plucking Model. The negative output gap continues to narrow as the US economy continues to recover from widespread vaccine delivery and the impact of COVID-19. After the output gap turns positive at the end of 2021, it is likely to expand for a short period and then turn downward. With no market clearing and no corporate deleveraging, there may not be much room for companies to increase leverage in the future, and the U.S. may not start a massive Jugra cycle like previous ones. At the same time, the scale of corporate debt is relatively large, enterprises borrow a lot of debt in the low interest rate environment, the rise of financing cost will increase the burden of corporate debt, accelerate the economic recession. Once the output gap turns positive this time, it could fall again faster than in previous cycles.
It is necessary to distinguish between the short-term natural rate and the long-term natural rate. The pandemic will cause long-term natural interest rates in the US to fall, while short-term natural interest rates will rise and then fall, depending on the pace of the pandemic and fiscal stimulus. For now, the impact of the epidemic is moderating, and short-term natural interest rates are likely to rise. A new round of infrastructure plans in the United States is still likely to come out, just a matter of scale and timing. The debt ceiling increase should be fine, the issue will be resolved by the end of 2021, and with the Fed poised to taper, short-term natural interest rates will rise further and bond rates will continue to rise for some time. Thereafter, short – term natural rates are likely to converge quickly towards long – term natural rates, while it is difficult to return to pre-pandemic central levels. Interest rates are like cars, and the Federal Reserve is not the driver but the passenger. Dragged down by natural interest rates, monetary policy rates cannot return to pre-epidemic levels.
The us output gap and interest rates will continue to rise, and the US stock market will continue to rise as the impact of the epidemic is blunted by widespread vaccination. There is no need to worry about pressure on stock prices from rising interest rates. Interest rates and stock yields are positively correlated with demand shocks, as they have been since 2000. However, under the long-term natural interest rate constraint, the output gap and interest rate may turn downward faster than in previous economic cycles, and the US stock market will face great downward pressure. However, if the US continues with several rounds of infrastructure and preventative interest rate cuts, the economic cycle will be stretched, the downward progress of the output gap will be interrupted, and the STOCK market will be pulled up, as it was in 2019.