Why in two days of trading stocks fell by 1700 points? Nobody knows this, but everyone wants to know. There are several options for the development of events, each of which can have rather impressive consequences on the real economy.
Stocks are falling as fast business expansion and higher wages will help lower profit margins
According to this theory, stocks are falling amid a good economic situation. This is the most optimistic scenario. Bloomberg's Joe Weisenthal encourages Donald Trump to consider this.
As the economy grows, companies expand, and with greater productivity, they will have to cut prices to attract enough customers. They will also have to pay higher wages in order to force workers to participate in expansion activities.
Competition for workers and customers will mean lower prices, higher wages and lower rates of return, so stocks will fall.
This is an optimistic scenario.
But is that so?
If so, this will be a turning point in key economic processes over the past nine years of recovery: as the economy recovered, companies almost did not expand, preferring to get a higher rate of return rather than expanding in search of a larger market share.
The most obvious point in favor of this option is the report, which came out on Friday just before the two-day drop during trading on the exchange and which reflects a wage increase of up to 2.9% – the highest figure since 2009.
Perhaps now companies are so eager for expansion that they are willing to pay higher wages. Perhaps this is what scares the markets.
Stocks fall because improved economic data will force central banks around the world to raise interest rates
Amid rising wages, central banks are likely to be worried about inflation. Or they will feel that there is an opportunity to "normalize" rates, which will give them the opportunity to reduce them again if the economy begins to soften.
In any case, this means that bankers will respond to good economic news by raising rates.
Higher interest rates will make investing and company growth more expensive.
Higher interest rates can also make stocks less attractive risk-adjusted assets.
Why keep stocks with an expected annual yield of 8% when the yield on safer bonds has increased from 4% to 6%?
In order for shares to remain attractive to investors in the face of higher interest rates, the price / earnings ratio should be lower, that is, the price of shares should fall.
Apparently, this is the most popular scenario in the markets: the yield on 10-year Treasuries has really grown over the past month.
But there is at least one obvious question that inevitably arises against the backdrop of these considerations: for most of last month, when profitability rose, stock prices also rose.
What has changed in the last few days?
Furthermore, observation of this story suggests that central bank acts arbitrarily.
Stocks fall because competition for scarce capital will lead to higher interest rates
The law on tax cuts has become a strange element of pro-cyclical economic legislation: at the peak of the economic cycle, the US government conducted a major tax cut.
This year, the federal government will have to raise $ 1 trillion to fulfill its obligations, largely due to adopted legislation.
We experienced a rather strange 20-year period when it was almost unimportant how much money the US government borrowed.
Demand for government bonds was endless; very low interest rates existed along with extremely high budget deficits.
But even in the Middle Ages, politicians spent a lot of time talking and worrying about the relationship between government borrowing, interest rates and private investment.
If you look at the transcript of the 1992 presidential debate, you will notice a lot of concern and debate about the relationship between the deficit and interest rates. Both George W. Bush and Bill Clinton signed major budget plans with the primary goal of reducing the federal budget deficit and lowering long-term interest rates. And they have succeeded.
What if we return to a world where tax cuts not only pour money into the economy, but also force the federal government to borrow hundreds of billions of dollars, while at the same time, the incentive to invest in business is growing?
Government and expanding companies oppose each other for a limited amount of capital. This should make investors picky and lead to higher interest rates and lower price / earnings ratios.
In other words: in this situation, stock prices should fall, bond yields should rise, and the cost of investment capital should increase.
A higher cost of capital will hamper investment, but at the same time lower tax rates and possibly improved growth prospects will contribute to this. A tax cut will reduce the benefits, as an increase in government borrowing leads to higher interest rates.
Economists would say that the effect will be felt in the long run, therefore, as a rule, economic models of the tax bill suggest more negative results in the futureas the increase in public debt negatively affected the economy.