It’s hard not to wonder: Is the stock market telling us something? True, the market’s record in forecasting recessions is horrendous. Stocks often move according to whim or fad. But just because the market is wrong much of the time doesn’t mean it’s wrong all of the time. Could last week’s turbulent trading be one of the times it’s right? By Friday’s close, stocks had dropped 6 percent for the week, a paper loss of $1.5 trillion, says Wilshire Associates. Are we staring at the next recession?
The sell-off originated in China with a weaker-than-expected report on manufacturing activity. This triggered a sharp drop in Chinese stocks, which spread to the U.S. and European markets. Behind this chain reaction is a huge transfer of economic power from advanced economies (mainly North America, Europe and Japan) to “emerging-market” nations (Brazil, Russia, India and China — called BRIC — and similar countries, such as Indonesia). They now overshadow the advanced economies.
Consider: In the 1980s, emerging-market countries plus poor developing countries accounted for 36 percent of the world economy (gross domestic product), reports Maury Obstfeld, chief economist of the International Monetary Fund. Now their share is about 56 percent of global GDP. There’s nothing inherently wrong with this. Indeed, the faster growth of these economies in the past explains why their share of global GDP has risen.
The trouble is that their growth is slowing. Of the BRIC countries, only India’s rapid growth has been sustained. Brazil and Russia are in recession, and China’s expansion has flagged. Moreover, several large problems dampen future growth prospects, says economist Hung Tran of the Institute of International Finance, an industry group.
One is high debt levels. Many emerging-market economies escaped the worst of the 2008-2009 financial crisis because their banks lent heavily and their businesses borrowed heavily. From 2008 to mid-2015, corporate debt in these countries, including bonds, exploded from $8.9 trillion to $24.5 trillion, reports Tran. China was a big part of this. In some countries (Thailand, South Korea), consumer lending also surged. The upshot: Borrowers now need to conserve cash to service their loans.
The other problem is the legacy of the boom in commodities — oil, grains, metals. From 1999 to 2011, commodity price indexes rose about 80 percent, says Tran, on the false assumption that China had an almost unlimited appetite for raw materials. It didn’t. The China bubble has popped. Price indexes have dropped from their peak by about 50 percent. Supply dwarfs demand; new investments have been canceled. Collapsing prices have devastated commodity exporters, led by oil producers. Commodities represent 45 percent of exports from both Brazil (iron ore, soybeans, sugar) and Malaysia (oil, copper). The China bubble has popped.
Here’s the picture that emerges. To offset that, China may be devaluing its currency — the yuan -- to improve the competitiveness of its exports. In advanced nations, growth seems stuck between 1 percent and 2 percent a year. With so much weakness, the world economy is vulnerable to events (say, North Korea’s nuclear bomb test) that reduce confidence. Any ensuing declines in business or consumer spending could plunge us into recession. It’s also feared that China is devaluing its currency — the yuan, also known as the renminbi — to improve the competitiveness of its exports.
Maybe that’s what the stock market is saying.
There are skeptics. Economist Mark Zandi of Moody’s Analytics argues that the threats of emerging-market countries to the United States are exaggerated. “The underlying strength of the economy is the job market,” says Zandi.” We’re close to full employment. Very little of the labor market is connected to the rest of the world through trade.” Exports constitute only 13 percent of U.S. GDP; the other 87 percent reflects domestic demand. In December, payroll employment expanded by a strong 292,000.
Still, even Zandi worries that a significant slump in stock prices would demoralize wealthy and upper-middle-class investors, who are the biggest shoppers and owners of stock. (He reports that the richest 20 percent of Americans represent 51 percent of income, 58 percent of personal outlays and 73 percent of net worth.)
Large losses could cause a negative “wealth effect”: When people feel poorer, they spend less (similarly, when they feel richer, they spend more). Economists have long believed that the wealth effect for stocks is small — about 2 or 3 cents for each dollar of profit or loss. But a recent study by Zandi and his colleagues found that, in some recent years, the wealth effect for stocks was as high as 12 cents. That would magnify considerably the impact of a major market decline.
To the crucial question — does the market foretell a recession? — there is not yet a conclusive answer. How much China slows and how the rest of the world responds are open issues. U.S. stocks may have overreacted. Whatever happens, this is not your father’s business cycle.
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