After repeatedly topping record highs this year, a major stock market index took a 2.5 percent dive on February 2; it was the biggest decline in the Dow Jones Industrial Average since Brexit.
Then, the following Monday, investors saw the Dow’s largest drop, points-wise, it had ever seen in a single day. Canadian stocks slumped as well, but they have been widely outperformed by US markets, so it wasn’t as much of a shock.
But this wasn’t a bubble bursting, according to the talking heads. As the drama unfolded over the first half of February, the market experienced what market-watchers call a “correction,” as another major index, the S&P 500, shed over 10 percent from January highs. When prices get lofty, eventually they have to come back down to earth. “It’s healthy,” they say.
Depending on who you ask, the recent boom in US stocks was either because of solid economic growth or because of emotion-based hype leading to rising prices, referred to as a “melt-up.” Whenever markets stumble, everyone wants to know why.
That question isn’t simple, and the following isn’t the answer, but more of a thought exercise.
There’s a dance between investors, central banks, businesses, and consumers that drives a lot of the price action.
Investors were excited about Trump cutting corporate taxes, and they saw higher corporate profits on the horizon. While now rising, historically low interest rates have allowed corporations to invest and expand.
Central banks are spooked by inflation as economies have healthy growth again. Job numbers were growing in the US and Canada, and this brings economies closer to what economists refer to as “full employment,” a percentage of unemployment that results in workers gaining more bargaining power in the labour market. This puts pressure on wages, and leads central banks to raise interest rates to combat inflationary pressure on the price of goods.
Generally, this bump in rates is precautionary rather than reactionary, as central bankers try to stem inflation before it happens.
Corporations see rising interest rates as a boon on profits. Existing debt gets more expensive to manage, and expansion that requires debt becomes riskier. Less profit and opportunity means less job creation.
Consumers see those same rising rates and see risk too, as mortgages and other debts get more expensive to manage. Corporate profits are largely driven by consumer confidence. If consumers have less to spend and tighten their belts, stock prices suffer alongside their corporate profits.
So how does the dance end?
Well, in the wake of this recent tango, Canada shed 88,000 jobs in January. Pressure on wages from lower unemployment and recent minimum-wage increases could have helped push employers to tighten up on labour spending.
As our central bank began raising interest rates last year, the January job report might make them proceed “ultra-cautiously” for now, BMO chief economist Doug Porter has told media.
If interest rates stay low, then we start the dance again. Debt remains cheap, consumers consume, corporations profit, and stock prices go back up, until the next “correction.”
Maybe it’s less of a dance, and more of a merry-go-round.