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Stock market slump raises concerns about the economy

By Masao Suzuki |
October 13, 2018
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San José, CA - On Wednesday and Thursday, October 10 and 11, U.S. stock markets slumped, with the widely followed Dow Jones Industrial Average or Dow down over 800 points on Wednesday and another 500 points on Thursday. While the market did recover a bit at the of trading week on Friday, with the Dow up about 250 points, uncertainty about the bull market in stocks and the ongoing economic expansion are back.

The U.S. stock market has been on a rise, or in a bull market, for more than nine years, making it the longest since World War II. This rise has been fed by the long economic expansion and rising corporate profits, which has also gone on for more than nine years, the second longest period of U.S. economic growth in history. The other important factor has been the low interest rates of the last nine years, as the U.S. central bank, the Federal Reserve, or Fed, printed trillions of dollars to save the financial system and push interest rates to close to zero. These low interest rates pushed down bond yields, leaving stocks a much more profitable place to invest. This has pushed the ratio of stock prices to corporate earnings to the second highest point in history, behind online the 2001 speculative boom in internet stocks.

But the Fed has been raising interest rates for more than three years now. At first this was at a very slow rate, with a quarter of a percent increase in December of 2015, and the next increase not until a year later, with another quarter point rise in December of 2016. The Fed picked up its pace in 2017, with three interest rate increases, all a quarter of a percentage point. There have been already three such interest rate increases this year, and a fourth is widely expected.

While short-term interest rates are still somewhat low at a little over 2%, the Fed rate increases have pushed up other interest rates too. The yield on the benchmark ten-year U.S. government bond has jumped to 3.2%, and for the last year has been higher than the average dividends paid by stocks, making bonds more attractive for investors looking at income. The interest rate on the standard 30-year mortgage has also been rising, reaching 4.9% last week, the highest rate since 2011. Rising mortgage interest rates have been holding back the housing market, with existing home sales falling for the last five months in a row.

But the housing market is not the only one showing signs of slowing. Auto sales are down 5.5% from year ago levels, as higher prices and rising interest rates take their toll. 0% financing on car loans has dropped by almost two-thirds from two years ago, as rising interest rates make this sales booster too expensive for more and more car makers. One confirmation that the auto market is slowing significantly is that Ford has announce major layoffs.

Ford blamed the layoffs on Trump’s tariffs on aluminum and steel as well as a range of goods imported from China. But while these tariffs are starting to bite manufacturing companies in the United States, the biggest factor has been the fall in car sales, which has hurt Ford particularly hard. It is common for large U.S. corporations to blame government policies when in fact it is the ups and downs of a capitalist economy that are really the cause.

But U.S. tariffs, and even more, the prospect that the United States is setting course for a new Cold War with China, are also causing economic jitters. Unlike the original cold war or competition between the United States and the Soviet Union where the USSR had limited economic ties except to its socialist allies (for example in 1959 almost half of China’s trade was with the USSR), socialist China today has extensive ties with the rest of the world. Not only is China a major trading partner with the United States, but it has also displaced the United States as Africa’s largest trade partner. While the United States remains first in trade for both Latin America and Europe, China is now number two and is quickly expanding both trade and investment ties.

There is also growing competition between the Unites States and China in many fields. China has more high-speed rail than the rest of the world while the United States has none. The same for manned rockets, where the United States must rely on Russian boosters. China is the world’s largest ship builder; the United States makes very little outside of military craft. While the United States and Europe dominate commercial jetliners, China is in the final stages of its own plane. China produces the most cars in the world and is going all out to develop the electric car industry. China is leading in renewable energy installation in terms of solar and wind. Most worrying to the United States is China’s push into high technology such at the next generation (5G) cell phones and artificial intelligence.

Rising U.S. interest rates also are having an impact on much of the Third World. Many countries with developing economies have seen their businesses borrow in U.S. dollars at much lower interest rates than they could do domestically in their own currency. But the increase in U.S. interest rates have led to a rise in the U.S dollar. The U.S. dollar has been the most expensive since the 1990s technology boom led to large inflows of capital boosting the dollar. But now more and more companies who borrowed in U.S. dollars are having a harder time to repay them with profits made in their own currencies.

Argentina is taking a $50 billion loan from the International Monetary Fund or IMF, the largest loan in IMF history. This loan comes with the traditional IMF requirements the Argentine government raise taxes and cut spending, deepening the recession in Argentina. Turkey’s central bank raised its interest rates to 24% to try to stop the fall in the Turkish lira, which is down 40% compared to the U.S. dollar this year. Turkey also faces more than a $100 billion in debts due in the coming year, but the higher interest rates will be a drag on the economy.

Neither Argentina, Turkey or Pakistan, another country talking with the IMF, are big enough to drag down the U.S. economy. But there is a brewing debt crisis in Italy, one of the world’s major economies. Italy’s economy is number nine in the world and number three in the Eurozone, after Germany and France. Italy has the second largest government debt (after Japan) of all the world’s large economies, and a debt crisis there would have a much bigger impact than the Greek crisis, as Italy’s economy is ten times the size of Greece’s. Italy’s government is a coalition of a right-wing, anti-immigrant party and a centrist anti-corruption party, both of which are more skeptical of the Euro than other European governments. Another crisis in the Eurozone is likely to spill over to U.S. economy.

The stock market is not a great predictor of what is going on in the overall economy, as day-to-day financial flows and investor emotion matter the most. But even if the stock market recovers and even if it hits new highs, rising interest rates, slowing housing and car sales, higher tariffs and trade war with China, and economic instability in the rest of the world are not going away.