Originally published at Project-Syndicate | Jul 25th, 2024
US stock markets have remained bullish in the face of deepening domestic and international risks, owing to three key factors. But with two of these coming under pressure, the durability of the current cycle will depend on the third: the US Federal Reserve.
CAMBRIDGE – Investors in US markets over the past year have shown a remarkable ability to brush off domestic and external risks to the economy’s well-being, as well as to the functioning of the global economic, financial, and trading system. This decoupling of risk from market sentiment has been driven by three factors: faith in the “sky-is-the-limit” prospects of certain technology firms, widespread confidence in American economic exceptionalism, and enduring faith in the US Federal Reserve to support financial assets. But two of these factors have lately come under pressure, leaving the durability of any positive outlook more dependent on the third.
A number of developments over the past year would normally have led to volatility, and a downward overall trend, in stock markets. The Hamas-Israel war – and the agonizing images of the large-scale loss of innocent civilian lives and massive destruction of livelihoods and physical infrastructure – has increased the probability of a region-wide conflict that could further disrupt shipping and trade, and drive up oil prices.
Moreover, the Sino-American relationship has grown only tenser. With the United States imposing yet more restrictions on technology-related exports to China, other countries are forced to navigate an increasingly complex field of secondary sanctions. The US presidential campaign has reminded everyone that new waves of tariffs against allies and adversaries could come as soon as next year. Meanwhile, domestic and regional elections have weakened moderate center-left and center-right parties in key European countries.
Investors’ ability to look past these developments cannot simply be attributed to the old mantra that “markets are not the economy, and the economy is not the markets.” Instead, markets have been insulated by the three factors mentioned above.
The first – ever-greater confidence in certain tech companies – reflects the impact of, and high hopes for, the artificial-intelligence revolution, a historic technological shock that is still gaining momentum. The direct effect is reflected in the US stock market’s impressive gains. But these have been driven mostly by just a handful of tech firms that are immediately connected to new generative and predictive AI models and their supporting infrastructure and hardware.
These firms have experienced eye-popping surges in their market valuations. The leading example, of course, is Nvidia, the market capitalization of which has exploded from under $300 billion in late 2022 to over $3 trillion this past June. Other winners include already dominant tech firms like Alphabet (Google) and Microsoft.
The market’s infatuation with these companies is not only understandable, but also warranted. They are at the forefront of a technological breakthrough that will fundamentally reshape much of what we do and how we do it. The products and services they are rolling out promise to drive widespread productivity gains that could improve the outlook not just for some companies, but for entire economies.
But while the reasons for optimism in these companies remain strong, the sharp increase in their stock prices has triggered a debate about whether a pause may be needed. After all, such unbridled enthusiasm could culminate in a costly bubble, the fallout from which would not necessarily be confined to one sector or economy.
Confidence about America’s continued economic exceptionalism is also coming under pressure. While overall consumer spending remains robust for now, lower-income households are already under considerable strain, as are small businesses. Much therefore depends on the US labor market, given its centrality to incomes, spending, and financial security. And here, the data are mixed, with some metrics – such as the overall unemployment rate – starting to flash yellow.
These developments make the Fed’s monetary policy even more important. The general assumption among investors is that “the Fed has our back.” This “Fed put” usually translates into expectations that any economic slowdown or bout of excessive market volatility will trigger a swift loosening of monetary policy. The Fed’s reactions to crises over the past two decades – from the 2008 crash to the COVID-19 pandemic – have reinforced this behavioral dynamic in US markets, as has its response to smaller episodes of market tumult, such as in the fourth quarter of 2018.
Does continued confidence in the Fed put remain warranted? Yes, but only if the Fed can look beyond its stated desire to get inflation down to its 2% target as soon as possible. That will mean cutting interest rates in the next two months to avoid an overly restrictive monetary policy, which in turn could cause undue damage to employment and the economy. Indeed, too tight of a policy could further weaken the first two factors, making it a lot harder for markets to continue to brush off the ever-expanding sources of domestic and international uncertainty.
Mohamed A. El-Erian: President of Queens’ College at the University of Cambridge, is a professor at the Wharton School of the University of Pennsylvania and the author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, 2016) and a co-author (with Gordon Brown, Michael Spence, and Reid Lidow) of Permacrisis: A Plan to Fix a Fractured World (Simon & Schuster, 2023).
