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Analysis

Trump should prepare for market drop

Monetary policy, not the White House, buoyed stock prices

by Desmond Lachman in Washington

Fri 4 Aug 2017

Donald Trump does not tire of pointing to the recent buoyancy of the US stock market as vindication of his economic policy proposals. He notes how since his election last November the Standard & Poor's 500 index, considered to be one of the best representations of the US stock market, has increased by more than 15%, reaching record highs.

A fundamental problem with this line of reasoning is that the same argument could be used to describe President Barack Obama's economic policies as a resounding success. During his eight years in office, the stock market as measured by the same S&P 500 index increased by around 230%.

Another problem with linking stock market performance to economic policy success becomes clear when examining the market's behaviour over the last few months. The initial 'Trump bump' in stock prices immediately following his election was caused by promises of substantial tax cuts and increased fiscal spending. But the likelihood of such policies being implemented has all but evaporated in the light of Trump's continuing political debacles. This should have caused prices to retreat.

Stock market prices are affected by numerous factors which often have little to do with underlying economic fundamentals. They are not a useful measure of the efficacy of an administration's economic policies. Instead, to assess the relative success of a president's economic policies one must look to indicators of how the economy might actually have grown and how employment might have increased. Judged by GDP growth or the increase in employment in the first half of 2017, Trump's policies appear to have had no more success than Obama's. Over the last six months the economy continued to recover at the slowest pace in the post-war period, and employment growth remains weak.

A more credible explanation for the stock market's buoyancy during both Obama and Trump's tenures is the unprecedented volume of liquidity created by the Federal Reserve and the world's other major central banks. Over the last eight years their combined balance sheet increased by $10tn. This helps to explain the synchronised increase in stock market prices across most of the globe, not just the US.

It appears the world's key central banks are preparing to start removing the liquidity which sustained the global stock rally. The Fed started to raise interest rates from their extraordinarily low levels in December 2015, and Fed Chair Janet Yellen intimated it may soon begin unwinding its bloated balance sheet. Remarks made by the European Central Bank, Bank of England and Bank of Canada suggest they might follow the Fed's example and begin to normalise their monetary policies in the near future.

It seems implausible that stock markets will remain as elevated as they are today once monetary policy normalisation begins in earnest. Financial market participants and Trump supporters should ready themselves for what might be a substantial correction in prices.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund's Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.

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