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Why Are Markets Faltering? And Why It Matters

Traders work on the floor of the New York Stock Exchange (NYSE). Michael Nagle/Bloomberg © 2018 Bloomberg Finance LP© 2018 Bloomberg Finance LP

In the past week, global equity markets have dropped sharply. It is natural to ask why this is happening, but it’s a fundamentally difficult question to answer. Nevertheless, the answer matters a great deal.

There are plenty of candidates for the culprit who spooked the market. President Trump’s favorites seems to be the Federal Reserve’s interest rate hikes, or Democratic victories in the November midterm elections.  It’s not hard to see why he might favor these explanations, since prominent alternatives include his trade conflict with China, or his threat to withdraw from NAFTA – both of which implicate dubious policy decisions he has made. Or there is turmoil at the White House, or investigations of campaign improprieties. Or there are the new and worrisome developments with Brexitor any of a sequence of standard economic or company news releases.

So which is it? What’s to blame? A first thought is that we do not need a single answer. Any given market participant could be concerned about multiple problems. Or you could have different market participants each with different concerns. That’s not an answer that would play well on CNBC, where bold statements about market psychology do best. But there are many, many participants in markets, ranging from algorithmic trading programs to hedge funds to day traders to giant pension funds. Nothing says they have to see the world the same way.  

Economic theory does offer us a hint about sorting plausible answers from implausible ones, though. The “efficient markets hypothesis” argues that markets quickly price in all available information. This would seem to help rule out the President’s preferred explanations for a market swoon. The Federal Reserve Board has been exceedingly transparent about its plans to raise interest rates and has made them known long in advance. The idea that Democrats would take over the House but leave Republicans in control of the Senate was the betting favorite throughout the months leading up to the midterm election. Why should markets react now to events that have been credibly forecast for a long time?

Such reasoning would point a finger toward news – those events that were unexpected and might cause investors to darken their view. That means more likely culprits would include revelations from investigations of the President’s behavior, or announcements about NAFTA withdrawal, or new tight and difficult China deadlines.

Of course, there are other reasons why markets may move, including herd behavior. Investors buy because they see others buying, or sell because they see others selling. This can either be seen as playing a bubble – “the valuations may be unjustified, but as long as people are enthused, might as well buy and make money off it” – or as a proxy for delving into the issue more deeply – “if everyone else thinks that President Trump and President Xi just solved China trade problems, maybe they know something I don’t.” It certainly seems, in the China trade context, that markets were far too optimisticabout the results of the Buenos Aires bilateral summit. It is hard to say whether the ensuing skepticism was due to a slow rethinking by investors or due to news such as differing interpretations of what was agreed, or the contemporaneous arrest of a Chinese corporate leader.

If it is so difficult to say why markets go up or down each day, why bother? Particularly with the Trump administration, markets seem to be one of the few checks on an otherwise determined and worrisome protectionist policy bent. President Trump seems relatively immune to reasoned arguments about what tariffs do, but he seems closely attuned to the stock market as a measure of his success.

Ill-advised protectionist policies may or may not be driving markets down. If President Trump comes to believe they are, it could be one of the few forces that could persuade him to steer away from a dangerous course. That could mean that, in trade and markets, things have to get worse before they get better.

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