The Dow jumped more than 100 points in early trading Tuesday, after the Commerce Department announced that core inflation rose just 1.8% over the past year, below the Federal Reserve’s annual 2% target. The data suggest that when the Federal Reserve’s FOMC meets next week, committee members will see little reason to push for an accelerated pace of interest rate hikes.
These numbers dovetail with other data, like last week’s jobs report, which showed the U.S. economy added 313,000 new jobs at the same time that the labor force grew by its largest 1-month increase in 15 years. The U.S. economy, it would appear, has reached a Goldilocks phase, in which good workers are scarce enough for employers to need to lure non-participating Americans back into the workforce, but not so scarce that it’s causing faster inflation.
Investors, for the most part, love what they’re seeing. The S&P 500 is once again close to all time highs, following February’s correction, while volatility has fallen significantly from its highs six weeks ago. But as evidenced by the fact that Tuesday morning gains quickly turned to Tuesday afternoon losses, many market participants remain nervous that we’re close to a market top, and that recent macroeconomic green signals could soon flash red.
Blackrock’s Russ Koesterich argues the reason good economic news can no longer sustain lasting stock market rallies is that investors have just become way more optimistic of late. “By virtually every metric, the U.S. and most of the major economies are accelerating for the first time in many years—and in a coordinated fashion,” he writes. “However, while both hard data and expectations are improving, in recent months the latter, expectations, seem to be improving faster than the former, hard data. In other words, economic releases are no longer beating expectations as frequently or by the same magnitude as was the case in the fall.”
There’s plenty of reasons to worry that investor optimism today has gone overboard. The Trump Administration looks set to go to war with the World Trade Organization, after enacting steel and aluminum tariffs on national security grounds, which the WTO is ill-equipped to adjudicate, and by continuing its policy of blocking all nominations to the WTO’s appellate body, a decision that could leave multinational organization powerless to resolve disputes by 2019. Trump envisions a world in which all trade negotiations are done on a bilateral basis, a system which would likely lead to higher overall tariffs and therefore lower profits for the multinational corporations that dominate the S&P 500.
The Trump Administration and the GOP Congress have also welcomed permanent, $1 trillion deficits after enacting a massive $2.2 trillion corporate tax cut with almost no corresponding cuts to planned spending. While the Republican Party took debt-hawkishness overboard during the Obama years, this complete about-face will take the U.S. economy into uncharted waters at a time when both the Fed and foreign central banks are slowing their purchases of U.S. government debt. That mortgage rates have risen so sharply since the beginning of the year could be evidence that this massive buying binge is already leading to a crowding out of private investment, as new home sales fell last month to a five month low.
Investors could also be growing complacent about the rest of the world. Turning back to the economic surprise index, you can see that the U.S. economy suffered through a nearly 18-month period when investors were consistently disappointed by economic releases back in 2015 and 2016. This coincides with what was a sharp slowdown in the Chinese economy, which sent shockwaves through both the Chinese stock market and global commodities markets, most especially oil.
Without the crash in oil prices that hurt investment and job growth in the U.S., it’s quite possible that the U.S. recovery would have pushed into higher gear back in 2015, rather than last year. That’s more or less what FOMC member Lael Brainard suggested in a speech earlier this month, when she argued the case for optimism towards the U.S. economy today starts abroad. “Many of the forces that acted as headwinds to U.S. growth and weighed on policy in previous years are generating tailwinds currently,” she said. “Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand.”
Sure, Europe and China look strong today, but there is surprisingly little discussion of whether we should expect this to continue. Though the Chinese economy is difficult for foreigners to analyze, given unreliable statistics and little transparency at the corporate level, there’s plenty of reason to believe that the turbulence of 2015 and 2016 is just a taste of what’s to come. As China researcher Dinny McMahon points out in a new book on China’s debt situation, China’s growth since 2008 has been based less on exports that on massive government-directed infrastructure investment. Though this has propped up the construction industry, which accounts for 20% of the Chinese economy, it has also led to the construction of more than 50 ghost cities filled with empty apartment blocks and unused infrastructure.
Since the financial crisis, the growth in government and corporate debt in China “has been one of the largest in modern history,” according to a recent Goldman Sachs analysis. What’s more debt continues to grow faster than economic growth, suggesting that policy makers still haven’t figured out a way to wean the economy off investment-directed growth. The Chinese have many more tools at their disposal to prop up the private sector, and much greater willingness to do so than the United States. But if a minor slowdown in the Chinese economy in 2015 caused so much damage to the U.S. economy, it will benefit us to wonder what a full-blown debt crisis might unleash.
Christopher Matthews is a writer who splits his time between New York City and Accra, Ghana, with an interest in the intersection of markets, the economy, and public policy. He previously held staff positions at Axios, Fortune Magazine, and Time Magazine, and has been published in Forbes and Debtwire.