The recent stampede by investors has erased about $5 trillion in value from global stock and bond markets in October alone. But that shouldn’t be severe enough to affect the economy, for now, according to economists at Deutsche Bank. Still, unless the markets regain their footing soon, the pressure for the Federal Reserve to reassess their monetary policy will continue to mount, they said. “Academic studies of the wealth effect find that households and companies don’t react to short-term fluctuations in their wealth but instead react to a moving average of where their wealth levels are,” said Torsten Slok, chief international economist at Deutsche Bank Securities, said in a note to clients. As the chart below illustrates, global markets shed roughly $5 trillion in market cap just this month, but the total value of equity and debt markets has increased $15 trillion from 2017.
“The bottom line is that we need a more significant correction before it will begin to have a meaningful impact on the economic outlook,” he said. The Fed said wages and prices are rising in its 12 districts and overall economic activity expanded at a “modest to moderate” pace, according to the Beige Book released on Wednesday. The report, which compiles anecdotal observations about the economy, by and large suggests that the Fed is likely to stay on course to execute its fourth rate rise of 2018 in December and deliver additional increases next year unless there is a more dramatic unwind in the financial markets. Much of the stock market’s volatility have been blamed on worries over the adverse impact of higher rates as the 10-year Treasury yield TMUBMUSD10Y, -1.35% spiked in early October to 3.261%, a level not seen since 2011. A rise in yields leads to steeper borrowing cost for corporations and eventually can slow economic expansion. It can also call make bonds an attractive alternative to more volatile equities. Gross domestic product grew 3.5% in the third quarter, compared with 4.2% in the second quarter, according to a government report Friday. Data showed that consumer spending rose in the latest quarter but was offset by a slowdown in business and residential investment. Even so, with U.S. stocks reeling, the threshold for the Fed to reconsider its hawkish stance may be near, according to Matthew Luzzetti, senior economist at Deutsche Bank. “The recent financial market turbulence should not affect the Fed outlook dramatically unless it becomes more severe and protracted,” he said earlier this month.For that to happen, the Deutsche Bank’s financial conditions index would have to move down to near zero, per the following chart.
“A further 10% decline in equities, which would amount to a roughly 15% decline from the recent peak…would be needed to tighten financial conditions by enough to materially impact the Fed,” said Luzzetti. U.S. stocks headed south Friday with the S&P 500 SPX, -1.73% and the Dow Jones Industrial Average DJIA, -1.19% turning red for the year as disappointing results from a handful of megacap companies weighed on investors’ sentiment. The sharp selloff this month has prompted at least one market expert to suggest that stocks are in the midst of a sustained downward spiral. “With the S&P 500 only five weeks removed from its all-time high, we’ve not been definitive about labeling this move a new cyclical bear market. But it’s very likely we are experiencing one,” said Doug Ramsey, chief investment officer at Leuthold Group, in a report.
He noted that the MSCI ACWI Ex-USA Index, a benchmark for 46 foreign markets, closed only 0.1% away from “official” bear territory and the market action reminds him of the dismal summer days of 1990. “While the big event in that year’s first half was the Japanese stock market’s collapse from its late-1989 high, foreign markets of all stripes were down sharply by the time the S&P 500 saw its final high in mid-July,” he said. Back then, the MSCI ACWI Ex-USA bottomed out ahead of the S&P 500, something which Ramsey expects to recur fairly soon.