Market plunge reveals growing investor pessimism in US economy

Markets had a rough day Tuesday with the S&P 500 index falling more than 3 percent, the Dow Jones Industrial Average shedding 800 points, and the 10-year Treasury yield falling to 2.91 percent — its lowest in three months.

While there is, as always, a confluence of factors influencing market fluctuations, excessive U.S. growth pessimism and excessive post-Group of 20 (G20) trade optimism carry a large portion of the blame.

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While the G20 meeting between President TrumpDonald John TrumpCNN's Camerota clashes with Trump's immigration head over president's tweet LA Times editorial board labels Trump 'Bigot-in-Chief' Trump complains of 'fake polls' after surveys show him trailing multiple Democratic candidates MORE and Chinese President Xi Jinping was a success in that the threatened escalation of trade tensions was pushed back 90 days, conflicting post-meeting communication and Trump stating that he was a “Tariff Man” left many investors worried about rising protectionism.

Indeed, beyond the political spin, it is difficult to foresee an imminent and substantial trade deal between the two economic giants. Addressing the structural issues related to forced technological transfers, intellectual property protection, industrial subsidies and market access in China will instead require lengthy negotiations and patience.

But still, while 2019 will likely feature increased trade protectionism, October’s 10-percent market correction and Tuesday's combined decline in stocks and Treasury yields reveals excessive growth pessimism.

With the U.S. economy growing at a strong 3-percent pace, the labor market churning out more than 200,000 jobs monthly, the unemployment at a 50-year low and private-sector confidence near all-time highs, recession odds remain quite low — Oxford Economics puts the odds of an economic downturn in 2019 around 20 percent.

Looking ahead, though, this divergence between markets and the economy could persist, driven by unsynchronized global growth, elevated and rising trade tensions, technology sector troubles, oil turbulences and the Federal Reserve’s tightening of monetary policy.

On the global front, there are similarities between the recent bout of temporary economic decoupling and the one that was present in 2014-2015.

A fiscally-stimulated U.S. economy has largely been insulated from slower global momentum, which has led to both a strong dollar and ongoing monetary policy tightening — both seen as potential headwinds for stock prices.

On the trade front, policy uncertainty remains extremely elevated in the wake of the Trump-Xi meeting. While the two leaders negotiated a three-month tariff time-out, President Trump subsequently tweeted that in the absence of a deal with China, he would “be charging major Tariffs against Chinese product being shipped into the United States,” stocking renewed investor fears.

Indeed, the most under-appreciated paradox in U.S. trade policy today is that increased protectionism is hurting the very companies the U.S. administration wants to protect from unfair trade practices.

Most visibly, the imposition of tariffs on key inputs like semiconductors is leading to heightened cost for the tech sector and disrupting global supply chains.

In addition, there is a less visible, but increasingly active effort by the Treasury Department’s Committee on Foreign Investment (CFIUS) to scrutinize U.S. exports as well as foreign direct investment in certain new technology sectors, such as artificial intelligence and robotics.

A request for notice published on the Federal Register last week gives businesses 30 days to comment on new export-control rules. These rules could have a severe impact on U.S. exports, business investment and GDP, if imposed.

The energy sector has also come under pressure of late with Brent crude price falling nearly $25 to the low $60 per barrel since its early October peak.

A combination of strong U.S. oil output due to smaller-than-expect transportation bottlenecks, firmer Organization of Petroleum Exporting Countries (OPEC) production owing in part to waivers granted for Iran’s oil exports and weakened demand have helped push prices lower.

With OPEC producers facing a dilemma of either cutting production to support prices but losing market share or maintaining production but losing revenues, the lead-up to Thursday's OPEC meeting remains turbulent for markets.

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All of these developments have made the Federal Reserve’s monetary policy normalization process even more interesting going into 2019. Indeed, while the Fed’s main focus remains the state of the economy, it is not indifferent to market movements, especially those that affect the economy.

Balancing a desire to tighten monetary policy gradually to avoid rising inflation and the development of financial market imbalances with the need to avoid excessive tightening that risk stoking market instability is not an easy task.

Last week’s dovish Fed communications, including speeches by Fed Chairman Jerome Powell and Vice Chair Richard Clarida, is symptomatic of this difficult balancing act.

How to communicate ongoing monetary policy normalization in the face of a strong but cooling economy without communicating excessive growth and recession pessimism will be the key challenge.

Gregory Daco is the chief U.S. economist at Oxford Economics.