Stocks ‘bloodbath’ shouldn’t really hurt

But there could be severe consequences ahead, with the economic outlook still uncertain.

The old adage that what goes up must come down reasserted itself with a vengeance this week. Local blue-chip shares lost almost 5 per cent of their value, bringing to a screeching halt what had been a steady boom in share prices on leading stockmarkets around the world, including ours.

Pundits have been calling the end to an unusually long period of low financial volatility. The S&P/ASX200, the index with the closest relationship with Australians’ superannuation balances, had enjoyed a heady few months, rising 7 per cent since October in sympathy with US blue-chip shares, which had boomed after Donald Trump signed into law massive US tax reform late last year.

While it’s been a week of drama in a relative sense, the first point to bear in mind is that not much has actually changed. Stock prices have dropped by far more without any damage to the economy.

Even after this recent correction, the US S&P 500 index is still an extraordinary 34 per cent higher than it was just two years ago. Certainly profits haven’t increased by anything like that over that period. US stock prices are still historically very expensive, and until recently at levels last seen in the late 1920s.

Even in Australia the drop that some headline writers called a bloodbath has left blue-chip shares almost 20 per cent higher than they were two years ago. It would take a much larger drop in stock prices to raise questions about the outlook for growth.

In any case, shares make up a very small proportion of most households’ wealth, even in Australia where compulsory superannuation exposes a big chunk of the population to the vicissitudes of the stockmarket.

According to the Australian Bureau of Statistics’ latest wealth survey, median households held $3300 in shares in 2016, and they had a combined total of $96,000 in their superannuation. So even large swings in stockmarket values won’t have much impact on their net wealth. Leverage buying of shares is also much rarer than it is for property, which limits the collateral damage from sharp drops in stock prices.

Reserve Bank governor Philip Lowe, in his first speech of the year this week, remains upbeat about the local economy, although he put a dampener on what had been growing speculation that the central bank would be raising rates over the next few months. “The RBA’s central scenario remains for the Australian economy to grow at an average rate of a bit above 3 per cent over the next couple of years. This outlook has not been affected by the volatility in the stockmarket over recent days,” Lowe said. “Many investors had been working under the assumptions that unusually low inflation and unusually low volatility in asset prices would persist, even with above-trend growth at a time of low unemployment,” he added.

For Shane Oliver, AMP Capital’s chief economist, the drop in stocks was entirely within the normal range and could even present a buying opportunity. “Share pullbacks provide opportunities for investors to pick them up more cheaply; while share prices may have fallen, dividends haven’t,” he says. “Periodic corrections in sharemarkets of the order of 5 to 15 per cent are healthy and normal,” he says, pointing out how Australian stocks dropped 5 per cent or more five times between 2003 and 2007.

The conventional wisdom is to say don’t worry: the drop in share prices is good news because the US economy is returning to “normal”, with higher rates of inflation, faster wage growth and higher long-term interest rates.

The second point is how extraordinarily premature this conclusion seems to be. The nascent inflation is yet to emerge and bond yields on government debt are still very low. As in Australia, US inflation last year didn’t rise above 2 per cent, even in circumstances where the global price of oil, one of the biggest inputs in business costs, increased by a fifth. And if they did increase, it would crush households’ and governments’ disposable income because debt, both private and public, remains at very high levels in most countries.

As for wage growth, one puny swallow doesn’t make a summer. US wages rose 2.9 per cent over the year to January, the US Bureau of Labour Statistics said last week — considerably faster than the present pace of 1.9 per cent in Australia. Sure, this was the fastest pace of growth since 2009 but the rise was concentrated among higher-paid workers. For the bottom 80 per cent of workers there was little discernible improvement.

A high degree of uncertainty still hangs over the economic outlook. This latest share price drop is far from a sign of good health. The long-term consequences of massive levels of quantitative easing remain to be seen. Central banks in the US and Europe have been pumping trillions of dollars into the financial system for a decade and they are yet to withdraw them.

The Fed has really only been talking about reversing its policy, not actually doing it. Our policymakers have pursued more conventional policy but we won’t be spared whatever long-run costs emerge from quantitative easing. It would be odd if such large sustained intervention in financial markets didn’t have severe consequences. We still don’t know what they are.