Martin Feldstein, Harvard economist and former Chair of the President’s Council of Economic Advisors, is adamant that the US stock market is going to fall as the economy moves into a deep and extended recession.
His latest expression of this view is published by Public Syndicate.
Mr. Feldstein gets to his conclusion by way of the bond market. He presents a picture of future interest rates that is not too different from mine, which began to unroll last December in my article, “Key Market to Watch in 2018: the Bond Market.”
Mr. Feldstein writes, “It would not be surprising if the rate on ten-year Treasury bonds rises to 5 percent or more over the next few years.” Currently, the yield on the 10-year US Treasury note is about 3.1 percent.
In my article last week, I argued that the yield on the 10-year Treasury note could go up to somewhere around 4.6 percent in the latter half of 2019.
Mr. Feldstein argues that the real yield could go back to a “normal historic level of over 2.0 percent.” Its current level is just over 1.0 percent.
I argued that a “more normal” level for the real yield was around 2.5 percent to 2.6 percent.
So, we are not too far different here.
The main difference in projections is in the expected rate of inflation.
Mr. Feldstein sees the expected rate of inflation picking up to 3.0 percent for reasons that will be discussed below, but this is over a little longer time horizon than I was writing about. My view of the expected rate of inflation was to remain around 2.1 percent for the near term.
So, add the expected real rate of interest to the expected rate of inflation, and Mr. Feldstein gets his 5 percent (2.0 percent + 3.0 percent) and I get my 4.5 percent (2.5 percent + 2.1 percent).
Why this rise in longer-term yields is important is that Mr. Feldstein believes that this rise will result in a decline in the price/earnings ratio applied to corporate earnings. Right now, the price/earnings ratio for the S&P 500 stock index is 40 percent higher than its historic average.
As longer-term interest rates rise, share prices will become less attractive to investors and, hence, share prices will decline.
Mr. Feldstein argues that the normalization of interest rates “could cause the P/E ratio to return to its historic benchmark.”
As just mentioned, the historic benchmark is 40 percent below the current level of the P/E ratio.
This collapse would, according to Mr. Feldstein’s estimates, cause household wealth to decline by $8 trillion.
What this would imply is that this scenario would be the “other side” to the scenario drawn by Ben Bernanke, former chairman of the Board of Governors of the Federal Reserve System.
Mr. Bernanke’s vision to get the US out of the Great Recession and then into a period of economic expansion was to supply sufficient liquidity to the financial system that stock prices would rise, and as stock prices rose, the wealth of American consumers would soar and this “wealth effect” would stimulate consumer spending and consumer spending. This stimulus would be the foundation of the turnaround and subsequent period of economic recovery.
What Mr. Feldstein is describing is the exact reverse of the Bernanke plan.
Why? Because the historic relationship between household wealth and consumer spending is so strong!
The historical research that supported this relationship was done by a young professor at Princeton University named Ben Bernanke.
This kind of decline in household wealth, Mr. Feldstein estimates, would cause a decline of about 1.5 percent in GDP. He adds, “That fall in household demand, and the induced decline in business investment, would push the US economy into recession.”
So, where does Mr. Feldstein see the rise in the 10-year yield coming from? Three points.
First, the Fed will continue to raise its short-term policy rate of interest. Given the Fed’s signals, the expectation here is that the current effective Federal Funds rate will go from about 2.20 percent to about 3.65 percent by the end of 2020.
I have been writing constantly about this path.
Second, there are the projected federal budget deficits. The Congressional Budget Office projects that the volume of publicly held debt will rise from about $15 trillion now to nearly $30 trillion “by the end of the decade.”
I have also written about this two weeks ago in “Federal Budget: Out Of Control.”
Third, Mr. Feldstein believes that the “very low and falling rate of unemployment” will eventually result in a return of a faster rate of inflation. Inflationary expectations will explode.
Mr. Feldstein is more pessimistic about inflation than I have been. This is where we basically differ in terms of future outlook.
But, we are still very, very close in our perception of what the future might have in store for us.
Note, however, that if the rate of inflation begins to accelerate, this will give more support to the Federal Reserve that wants to continue to raise its policy rate of interest. The president will have a harder time arguing against the rate increases if inflation is becoming a problem again.
A lot of pressure still rests upon the Federal Reserve System. The Fed worked very hard to underwrite the historical performance of the stock market in the period after the Great Recession.
A stock market reversal cannot be fully put on the shoulders of the Fed if Mr. Feldstein turns out to be right. An out-of-control federal budget situation, one that would also contribute to a resurgence of inflation, is not the fault of the Federal Reserve.
In conclusion, let me just reiterate what I suggested in December 2017: the key market to watch in 2018 is the bond market. Keep your eye on what is happening there.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.