Even after the recent decline in U.S. stock market, its stock market has generally done very well over the past several years, and has generally been among the world leaders in terms of performance. Over the past year, popular stock market averages in the U.S. have gained about 8%. Over the same year the Dow Jones Global Index has lost about 1% (see below).
From the way the U.S. stock market has been outperforming most other foreign markets the last few years one might assume it is also leading the world in economic growth. But this is far from the case. Based on statistics from the Organization for Economic Cooperation and Development (OECD), economic growth in the U.S. is quite average, or even below average, compared to global economies. Economic growth in China and India far exceeds that in the U.S., and even European growth is not far from levels we have seen in the U.S. In 2016 U.S. real economic growth was reported at 1.5% and in 2017 at 2.3%. During the same 2-year span the overall U.S. stock market rose almost 35% (see following two graphs).
Ironically, the U.S. stock market has been a major beneficiary of the economic problems around the world. Whether it's weakness and unrest in Europe, a consumer slowdown in China, emerging market debt concerns or international military threat, the flight to the safe-haven of the U.S. has kept the U.S. stock market strong while others have faltered. Also, while I have regularly commented on the very low interest rates in the U.S. over the last decade, low interest rates has been the rule in many other countries as well. Countries like Japan, most of Europe, and others have had interest rates even lower than the U.S. And especially as the Federal Reserve has begun to raise rates over the last couple years, while rates in other countries have stayed lower, this has strengthened the U.S. dollar compared to most of these other nations. This has then attracted more foreign money into the U.S., and much of that, into the stock market. It has been a confluence of positive factors that has kept America's market near the top of the leading performers in the world for most of the past five years.
While expanding (and record) profit margins have something to do with the increased valuation of the U.S. market (though much of that is because of financial leveraging – selling bonds at very low interest rates and buying back company stock), expanding valuations are mainly responsible for the change in relative overvaluation of the U.S. market compared to foreign markets As a result, compared to foreign stock markets, the U.S. stock market is now one of the most expensive in the world. The graph below from Fortune.com compares global stock market valuations using the cyclically adjusted price-earnings ratio, or CAPE, which adjusts valuations for changes in the economic cycle.
The next graph below shows the amazing change in valuation of the U.S. stock market compared to the size of the country's economy, Gross Domestic Product (GDP). (Note that the St. Louis Fed only has data on this until the end of 2016. Given the 20% increase in the U.S. stock market since then, this stock market valuation to GDP has only grown more extreme.) We see that it was not until the late 1990s stock market bubble in which stock market valuation to GDP even exceeded 100%. The market peak of 2000 was nearly 50% higher than that, and the U.S. market has since eclipsed that late 1990s stock market bubble valuation as well.
Will Rising Interest Rates Pop this Bubble?
In recent weeks we have had the president of the United States saying the Federal Reserve has “gone crazy” with its interest rate increases in the last couple years. It is understandable that he and his administration are very concerned about having this stock market bubble break on his watch. And it may very well be the case that higher interest rates will break this bubble, and in turn, cause many economic problems down the path. If that's the case however, it only shows how fragile and artificial the economy was in the first place in which raising interest rates a couple percentage points could have such a devastating effect.
Compare the “crazy” Federal Reserve rate increases in recent years to much sharper and larger interest rate increases in past years and decades, and all of those starting from higher levels. The Fed Funds rate has increased about 2% in the past three years, increasing from less than 0.25% in November of 2015 to almost 2.2% today (see graph below).
Compare this recent rise to the 4% increase (1% to 5%) in just over two years, from April 2004 to June 2006 to break the housing bubble that the Fed had created. Or the 3% increase in just 16 months, from December 1993 to March 1995. Or the 3.25 percentage point increase in just one year, from March 1988 to April 1989. There was also the rise from 3.5% in January 1972 to 10.5%, in August 1973, an incredible 7% increase in barely a year and a half. Or the granddaddy of them all, where, in their effort to squelch high inflation, rates were increased from about 9.5% to almost 19% in just three months,from August 1980 to December of that year.
If anything, not only are today's interest rates still about the lowest in history, the increase in interest rates over the past three year periods is one of the smallest and most predictable increases during a period of rising rates. Indeed, as I have written before, the Federal Reserve was telegraphing to market participants more than seven years ago to be prepared for higher interest rates. It was also widely relayed by the Fed back in 2008 and 2009 that those interest rate levels below 1% were emergency level rates in order to deal with the financial instability at the time. Those “emergency” level rates lasted for over eight years. Indeed, the only question for anyone listening to the Federal Reserve back then, and for years afterwards, is why it has taken so long to bring interest rates anywhere close to normal interest rates. And even after these increases, the U.S. Fed Funds rate is still nearly the lowest that has existed in the last sixty years, aside from its near-zero percent interest rate panic campaign, begun in 2008. Just to reach anything close to historically normal interest rates would require rates increasing by at least 3% or 4% from today's levels.
If the Market Break Turns into a Rout, the economy's dominoes fall
But of course, the president, and most of Wall Street, is terrified that these rate increases will pop the financial and economic bubble that they are all so dependent upon. If the current market break turns into something more permanent, the big domino of the stock market will set other dominoes in motion. Entire sectors of the economy are now dependent upon the twin financial scheme of an inflated stock market and below-inflation interest rates. The financial sector is a direct beneficiary and not only earns hundreds of billions a year by riding higher stock market and asset values, but similar amounts as intermediaries in selling government bonds and in corporate America's leveraging program. That's where they take advantage of the miniscule interest rates and investors' desperate thirst for yield, by selling corporate debt at very low interest rates and then buying up their company stock.
The real estate and mortgage market is very dependent upon today's very low interest rates as well as with the consumer confidence that a rising stock market brings. Even the barely 1% increase in mortgage rates over the past year is sending ripples through the real estate market, with last month's U.S. home sales said to be the lowest in three years. And this is with average 30-year mortgage rates still below 5% and 15-year rates barely above 4%. Until the Federal Reserve man-handled interest rates in 2008, the U.S. had not had a period in more than 40 years in which the average 30-year mortgage rate fell below 5%, with rates above 7% for nearly all those years, and above 10% for about a decade. Obviously, a further return to normalcy in mortgage rates will crush the real estate market.
It would be a similar picture with auto sales. In the past year, average 48-month loan rates have increased about 1%, rising from about 4% to about 5%. Here too, with this modest rise in auto loan rates, they are far lower than have existed for the last five decades, which scarcely fell below 7% during all that time (see graph below). Over the same time that auto rates have generally fallen, American consumers have taken on longer auto loans. According to Edmunds, the average new car loan in America is now exceeds sixty-nine months, almost six years. With record-high loan lengths and record-high auto prices, significantly higher interest rates will bring a sharp end to the auto market boom.
Any significant decline in the stock market, especially as interest rates are rising, will have a sharp impact on the real estate and auto markets, but the declines in these industries will then also have a knock-on effect on related industries. Rising interest rates are also giving cover for credit card companies (which already have fat profit margins), to rise interest rates further on their borrowers. Rising credit card rates certainly won't be a great help to those consumers already struggling to pay their bills.
Besides these more obvious effects are two factors that are a bit more hidden to the consumer, but perhaps the biggest concern for governments. The first is how rising interest rates, combined with a falling stock market, affect pensions, especially public pensions. Those affects will then impact pension-holders, but eventually taxpayers, as they are called on to pay for shortfalls in pension coverage. The second factor is how interest rate rises and a falling stock market impact government finances, again, with the consumer and taxpayer to pick up the pieces. With record-high debt levels already, these factors may easily snowball governments and their taxpayers on a downward spiral. Governments will do everything they can to avoid these potentially disastrous scenarios by keeping the stock market elevated and interest rates as low as possible. If they fail, the consequences will be much more visible for everyone to see. I'll talk about these a bit more next time.