It was the best of times, it was the worst of times. Why did the stock market fall? No reason, and every reason. There doesn’t need to be a catalyst. Sometimes the market is simply going to do whatever the market is going to do, but the list of worries was already there. Going forward, investors will weigh near-term optimism about the economy against fears of the future – and those fears currently appear to be overdone. Expect further volatility (upside and downside) in the near term.
The economy is in excellent shape. Growth remains strong, the job market continues to tighten, and inflation is expected to remain moderate. But there has been a long list of worries: tighter Fed policy; higher long-term interest rates; trade policy disruptions; demographic constraints; and global economic risks. In the bond market, there have been upward pressures on yields: strong economic growth; tighter monetary policy; sharply rising government borrowing; and the unwinding of the Fed’s balance sheet. However, long-term interest rates abroad have remained low, limiting the increase in U.S. bond yields. Inflation, while a bit higher in 2018, is expected to remain moderate – hence, unlikely to drive yields up sharply. Until recently, bond market volatility had been extremely low (the calm before the storm), which typically results in a sharp revaluation. All else equal, higher interest rates are a negative for the stock market, but a weaker stock market is a positive for the bond market (higher bond prices, lower yields).
The strongest argument for slower economic growth is demographic constraints. Labor force growth has slowed. Slow labor force growth and moderate productivity growth imply that long-term potential GDP growth ought to be in the 1.5-2.0% range. We’ve exceeded that this year, boosted by fiscal policy (tax cuts and increased spending), which will continue into 2019. However, growth has been fueled by a further decline in the unemployment rate – and the unemployment rate can’t fall forever.
Productivity growth could pick up. Growth in output per worker has been relatively lackluster since the recession, in part because of a slower pace of capital investment. The tighter job market could lead to a more efficient use of labor. Technology changes (robotics) have helped boost factory output per workers, but partly at the expense of jobs (it’s estimated that up to half of the manufacturing job losses since 2000 have been due to technology). Foreign trade has been a significant factor in U.S. productivity growth in recent decades, as the loss of low-end jobs has been offset by the addition of higher-end jobs.