Stock gains are not just a result of animal spirits

An economy that for years has seemed locked in a depressing “new normal” phase is at long last showing some signs of returning to something closer to an “old normal”.

Last week’s financial headlines included a new high for the stock markets and strength in the US manufacturing sector. The broader mix of market and economic data from around the world in the last few months also points to a world where a vicious economic cycle isn’t looking quite as scary and may even be ending.

Consider how things looked one year ago. The world economy seemed hopelessly trapped in a cycle of low growth and low inflation. Markets recoiled at the mere possibility that the Federal Reserve would raise interest rates. Populist political insurgencies seemed to threaten yet more financial market chaos.

Now, interest rates and inflation forecasts have risen substantially from last winter’s lows; financial markets are shrugging off — or even rallying at the possibility of an imminent Fed rate increases; and it is all taking place during Donald Trump’s presidency.

There can be no assurance that this pattern will continue, and there are some things to worry about on the horizon, not least that the Trump administration could follow through on some of its threats to disrupt global trade and diplomatic relations. Long-term interest rates remain low by historical standards across most of the world, suggesting that global bond investors aren’t fully buying into a return to stronger, more consistent growth.

Buoyant optimism

But the pivot since Election Day is huge. The Standard & Poor’s 500 index is up 12 per cent since November 8, the London FTSE 100 index reached a new high on March 2, and other global markets have grown nicely in that span. Ten-year Treasury bonds now yield 2.45 per cent, up from 1.85 per cent on Election Day, suggesting investors believe higher growth and inflation are more probable than had seemed likely just four months ago.

Much of the buoyant optimism on Wall Street is driven by investors’ expectations of corporate tax cuts and deregulation under the Trump administration. But there is also some real improvement in the economic data underneath the shifts, reflecting economic forces that have been underway for years. And this resetting of expectations is evident in market data beyond the always erratic stock market.

On March 2, that took the form of a new survey of manufacturing supply managers that showed the factory sector is expanding at a breakneck pace. As recently as August, that same index from the Institute for Supply Management was contracting.

Those numbers followed positive readings on retail sales, industrial production and the job market.

For years, a theory that the major world economies were stuck in a pit of a “secular stagnation” had gained hold — the idea that low economic growth, low inflation, low interest rates and weak productivity growth were all reinforcing each other in a vicious cycle.

There’s hardly enough evidence to toss that theory aside, but there are many reasons to think things are now looking up.

For example, bond market prices now suggest that investors foresee consumer price inflation in the US at 2.03 per cent a year over the coming decade — consistent with the 2 per cent inflation the Fed aims for. It only recently reached that level, however, after being as low as 1.2 per cent in February 2016. And it’s not just the US.

Similar measures of inflation expectations have risen in Germany, Britain and other advanced economies.

For a window into the changing mindset of investors, consider some news around the Fed. William C. Dudley, the president of the New York Fed, said in an interview that it would be fair to assume that the central bank would raise interest rates sooner rather than later, given the improving economy.

“There’s no question that animal spirits have been unleashed a bit post the election,” Dudley told CNN.

Interest rate increase

Fed watchers interpreted that to mean that an interest-rate increase could be on the way in mid-March, just three months after the last increase in December. Yet that did nothing to slow the 1.4 per cent gain in the Standard & Poor’s 500 on March 2 and may even have contributed to it, as a sign of the Fed’s confidence in the economy.

A year ago, hints that the Fed would move quickly with rates would have sent markets into a tailspin. As 2016 began, Fed leaders were expecting to raise rates four times in that year, plans that helped send the stock market plummeting and measures of economic pessimism soaring. Then they backed off and only raised rates once.

Since a stock market rally began on Election Day, there has been plenty of discussion about a Trump effect. And no doubt a big part of the improvement has resulted from expectations that the new president’s policies will help corporate bottom-lines (and that some of the risks of his trade agenda won’t materialise).

But it’s worth keeping in mind that a so-called Trump bump arrives as the economy is closing in on its full productive capacity. It is getting to the point where a cycle of rising wages and higher inflation necessitates higher interest rates.

That, in turn, reflects policies from the Obama administration and the Fed that long predate Trump’s election.

Conventional economic theory predicts that if a government tries to increase deficits at a time of full employment, the results will be some mix of higher inflation and higher interest rates, crowding out investment.

So if tax cuts, more military spending and other Trumpian policies add to deficits at a time the economy is already running at full blast, rising prices and rising rates are exactly what we would expect to see.