Sir Isaac Newton famously said of the stock market that he could calculate the movement of the stars, but not the madness of men. We have to wonder what he might have said about today’s exuberant stock market. At a time when downward risks to next year’s economic outlook from both at home and abroad keep accumulating, the stock market keeps setting record after record of new highs.
Start with the risks at home. Irrespective of who wins the forthcoming election, our dismal public finances are bound to get worse if either of the candidates fulfill their reckless budget campaign promises. Kamala Harris is promising a slew of expensive public spending programs while Donald Trump is promising large unfunded tax reductions. Given that our budget deficit is already some seven percent of GDP, additional spending or further unfunded tax cuts would put our 100 percent of GDP public debt level on a truly unsustainable path. One would have thought that unsustainable public finances would be of concern to the stock market in that they could bring higher interest rates or a dollar crisis in their wake.
Worse yet, if Donald Trump was elected, we could be well on our way to an economically destructive international trade war. Trump has indicated that he intends to impose an import tariff of 60 percent on China and of 10–20 percent on the rest of our trade partners. That is bound to invite retaliation by our trade partners and take us back to the beggar-thy-neighbor policies of the 1930s.
Yet another major domestic economic risk that is in plain sight is the slow-motion commercial property market train wreck. With office vacancies at record high levels as a result of more work being done from home, office building prices in many major cities have fallen by more than 50 percent. This has to raise questions as to commercial property developers’ ability to roll over the approximately $1.5 trillion in property loans that fall due by the end of next year. A wave of property defaults could trigger another round of the regional bank crisis given the small and medium-sized banks’ high exposure to commercial property lending.
Turning to the risks brewing abroad, it seems to have escaped the market’s notice that two major wars are raging between Russia and Ukraine and between Israel on the one hand and Hamas and Hezbollah on the other. There is a real risk that the latter war could spread to the rest of the Middle East. That could have major implications for energy prices if it caused oil supply disruptions from the Persian Gulf.
That the external economic outlook is souring in a big way also seems to have escaped the market’s notice. China, the world’s second largest economy, now appears to be at the start of a Japanese-style lost economic decade as a result of the bursting of its housing and credit market bubble as well as President Xi’s shift to market unfriendly policies especially towards the high-tech sector. Meanwhile, in Europe the German economy appears to have run out of steam while France and Italy are saddled with highly compromised public finances and with a lack of political willingness to address their budget problems. This would seem to make it only a matter of time before we have another round of the Eurozone debt crisis.
As Donald Rumsfeld might have said, these are the known-unknowns. However, experience teaches that it is all too often the unknown-unknowns that throw a spanner in the works. This makes it all the more surprising that current stock market valuations are so stretched despite the many known risks that can be easily identified.
Maybe next year we will get lucky and none of the many risks to the economic outlook mentioned above will materialize. However, it would seem that a market not seized by irrational exuberance should be pricing in at least some chance that a number of these downside risks will materialize.
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