Fiscal and monetary tightening to crash global stock markets?

Those who decided to ‘Sell in May and go away’ have been well rewarded in the worst May for the Dow since 1940. The Dow Jones Index fell by 7.9 per cent in May and the more broadly based S&P 500 by 9.9 per cent, its worst May performance since 1962.

Is this a red light flashing danger ahead, or should investors buy on this dip? Investment gurus are all over the place. Is this a falter on the ‘Road to Recovery’ or the end of a long bear market rally?

ArabianMoney thinks fiscal and monetary tightening suggest a far bigger stock market decline is in prospect, and these things tend to happen rather suddenly, although the warning signs are always pretty clear if you care to look.

Contracting money supply

Let us start with monetary policy. At first sight the Fed’s commitment to almost zero interest rates for as long as it takes looks a big plus. However, interest rates paid on commercial debt (see this article) and more risky sovereign debt are on the way up. That is monetary tightening not easy money.

Then again the zero interest rate policy is also not delivering the goods. The actual money supply contraction right now in the United States is only comparable to the 1930s (see this article).

Those who rest their bullish case on low interest rates are therefore barking up the wrong monetary tree. Yes, money supply drives asset prices. But money supply is decreasing, not increasing, and what will deficit cutbacks in Europe do for money supply next? This can only be another negative.

Consider this from Puru Saxena in Hong Kong: ‘In our view, monetary policy determines the fate of every asset-class and as long as interest-rates are low, the ongoing bull-market should continue. In fact, history has clearly shown that each bear-market in the past was preceded by a period of significant monetary tightening. In every previous bull-market, rising interest-rates was the straw which broke the camel’s back.’

Commercial interest rates rising

Agreed, money supply governs the market. But the important thing to note is that it is already tightening now with the re-pricing of global risk. This is a consequence of the massive hit to the global economy in the credit squeeze of the autumn of 2008. Low interest rates offset this problem for a while. But they have not solved it, and they were not enough to stop a big monetary contraction which is still ongoing.

Let us remember we are in a deleveraging cycle and that is deflationary and not inflationary like a credit boom. The only boom has been in public debt, and in the long run that is bad for the private sector, not good. Still the net result is a declining money supply which is the stuff of depressions not recoveries.

This leads us back to fiscal policy as the other perhaps more obvious reason not to be terribly optimistic about the outlook for stock markets this summer. Just look at all the budget cutbacks across Europe. Is this not going to have an impact on global demand?

Cheaper euro

Yes a cheaper euro has an offsetting effect. But as with low interest rates is it enough to totally counter the coming downturn in demand? Remember the euro-zone does most of its trade internally and not externally. No, any logic suggests an age of austerity in government spending in Europe is not good for immediate GDP growth.

European governments seem to be rushing to see who can apply the biggest cuts. The new UK Prime Minister is also now hinting that higher interest rates are coming soon. None of this is good news for economic growth.

Global stock markets are still pricing in a fairly rapid recovery in the global economy and that is simply not the outlook if you consider what is going to happen to public spending to reduce deficits and that the money supply is contracting at the fastest rate since the 1930s.

And if you want to know why some investment gurus are getting this wrong it really seems to be a genuine misreading of the money supply situation. But then all would agree that interest rates will one day have to go up and that this will bring asset prices down, the only disagreement is on when not if. There is nothing here for investors, except high risk and the possibility of extinction.

Peter Cooper
for The Daily Reckoning

The Daily Reckoning