Higher Rock Education - Economics Blog

Monday, September 12, 2016
I have read several summaries of the stock market's 394 point plunge Friday, September 9, 2016 and find it very interesting that the North Korean test of a nuclear weapon was barely mentioned. (Links to the articles are furnished below.) Instead the focus was on the greater probability of an increase in interest rates following the FOMC's meeting next week and some tightening by the European central bank. Teachers can use this as a teaching moment for students interested in what drives stock prices.

In our lesson, Supply and Demand – Understanding the Dynamics of the Stock Market, we state that expected future earnings drives stock prices, so let's use Friday's market move as a test. Why should these activities reduce expected future earnings? Why wouldn't a nuclear test in North Korea impact the market?

Mario Draghi, the European Central Bank's president hinted that the central bank plans to cut back on purchasing securities, a move which would raise interest rates. It is understandable that Mario Draghi's comments would be scrutinized closely by investors. The European economy is weak, and has suffered from many recent events which have contributed to little or no economic growth. These include the debt crises faced by many EU countries, the migration of refugees, which has heightened tensions between nations and citizens, Brexit, and most recently the alarming increase in nonperforming loans. 

The ECB's monetary policy has been to add liquidity, hold rates down, and stimulate investment with a massive purchase of both government and private debt. Interest rates are actually negative, meaning banks pay the central bank interest to hold their reserves. Lower rates are important for at least two reasons. First, lower rates traditionally stimulate business expansion. Second, many EU countries have accumulated massive amounts of debt. Lower rates are needed to help these governments manage their interest expense. Draghi's comments imply that the European economy has responded better than anticipated following Brexit and is expected to grow. If true, then this should be good news for companies because earnings should increase. In this case an appreciation of stock prices is expected. But if this monetary policy is premature, companies who invest heavily in European countries can expect lower earnings if rates increase and discourage the European economy's recovery. I suspect most investors believe it is too soon.

Many members of the Federal Reserve's FOMC have been speaking out and implying that it may be time to increase interest rates at their meeting September 20 and 21. The FOMC (Federal Open Market Committee) sets the Federal Reserve's monetary policy. Chairwoman, Janet Yellen stated at a recent conference in Jackson Hole that, "The case for raising U.S. interest rates has strengthened in recent months because of improvements in the labor market and expectations for moderate economic growth." On Friday, Boston Federal Reserve President, Eric Rosengren also hinted it is time to consider raising rates. Mr. Rosengren has been one of the members who consistently voted for expansionary policies. These comments, and others by the more dovish members, have increased the odds that the Fed will begin to raise rates at their next meeting. Investors sold stock Friday because higher borrowing costs discourage investment. The implication is also that the economy is approaching the peak of a business cycle, which means growth will slow. These are both precursors to lower corporate profits.

It is understandable these events together attracted the bears. However, I have a hard time understanding why the response was so dramatic. After all, a rate hike prior to the end of 2016 has been expected for many months. I do not think a modest increase in rates would discourage many investments when interest rates are near historical lows. If I am correct, the downturn should be short-lived because investors will conclude corporate profits will continue to rise.

In the articles I read, the North Korean nuclear test was only mentioned as causing uncertainty in the Asian markets. This too is very understandable. Investors like certainty, so the resulting political uncertainty would cause concern. However, North Korea trades with few countries, so it does not directly impact other global economies (except China which is its largest trading partner). It is doubtful a nuclear test will directly impact the earnings of Japanese and South Korean companies. The impact on earnings of American companies would be minimal.

While the North Korean test understandably received a great deal of press and caused world-wide concern, it had a minimal impact on the prospects of future economic growth. Of course that would change if the risk of nuclear war escalates. It goes without saying that a nuclear war would have a devastating effect on everyone's economy!

CNN Money - Summer's Over? Dow Plunges Almost 400 Points
Market Watch - Dow Logs Nearly 400-point Drop as Rate-hike Fear Grips Wall Street
Value Line - Stock Market Today: September 9, 2016
Bloomberg - Stock Sinks with Bonds, Dollar Rallies as Complacency Broken
Wall Street Journal - Volatility Strike Brings Abrupt End to Markets' Summer Vacation

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