August 25, 2015
U.S. News & World Report, August 25, 2015
Yesterday, markets in the U.S. and world-wide experienced dramatic falls that saw the Internet and social media panicking over #BlackMonday. As U.S. and other global markets begin to rebound, though, there are a couple of important takeaways.
The most important point to remember is that the stock market is not the economy. The ups and downs of the market have no direct correlation to gross domestic product. The plunge of more than 20 percent in the 1987 crash here in the U.S. did not correspond to any actual bad news, past or future, in the economy. Even over the longer term, there is no tight link. The stock market lost more than 40 percent of its value in the 1970s (in real terms), but it more than doubled in the 1980s. GDP growth averaged 3.2 percent from 1970 to 1980 and 3.3 percent from 1980 to 1990.
Even in principle, the stock market is not supposed to be a barometer of economic activity. It is supposed to represent the current value of future profits. This means that if people expect the economy to slow down, but also expect a big shift in income from wages to profits, then we should expect to see the market rise. So there is no sense in treating the stock market as a gauge of economic activity; it isn’t.
In terms of this specific downturn, China’s problems were a huge factor. It is very clear that China had a serious stock bubble. Its market rose by more than 60 percent from the start of the year to its peak in early June. At that point, it was more than 150 percent above its level a year ago. Even with the recent plunge, it is still well above the year-ago level.
It was inevitable that this bubble would burst—the only question was when. The collapse undoubtedly hurt some Chinese investors, many of whom recently entered the market, often with large amounts of leverage. However, the direct impact on the Chinese economy is likely to be limited. These people would not, in aggregate, have enough wealth so that any reduction in spending would hit the economy in a big way. (Remember, people who were in the market last year are still way ahead.) There may be a political issue for the Chinese government, though, which apparently encouraged people to buy into the market.
There is a larger issue for the Chinese economy: its ability to convert from an investment and trade driven economy to one driven by consumption. This is not an easy task and it would not be surprising if China finds it difficult. This could also be troubling for the United States.
For the U.S., a failed transition for China will lead to an increase in its trade surplus with the world. If the value of the yuan continued to fall, China would export more and import less. Slower GDP growth would further increase the surplus. If we assume that this increased trade surplus is shared evenly between the U.S., Europe and the rest of the world, this implies an increase in the U.S. trade deficit of roughly $70 billion. That could reduce GDP growth over the next year by $105 billion, or a bit less than 0.6 percent. A 0.6 percentage point hit to GDP is hardly trivial, but not the sort of thing that gives us another recession.
Finally, it is worth noting that investors will often react irrationally in a situation like this. A lot of people see the market falling, think that it’s time to get out, and sell. When the market rebounds and prices start to go up, these same people often decide to buy in at a higher price. As a result, they lose a lot of money. This is bad news for them, even if may not mean much to the overall state of the economy.
The moral of this story is that if you have money in the stock market, it’s probably best not to panic. If you don’t have money in the market, then there is definitely no reason to panic.