No, Mr. Krugman: A weak economy is not good for the stock market

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In trying to explain the U.S. stock market’s recent strong rally from its worst ever monthly sell-off in March, economist Paul Krugman advances the idea that a weak U.S. economy could be good for the U.S. stock market. By so doing, he incorrectly intimates to the unwary investor that the weaker that the economy becomes, the better it will be for the stock market.

Never before has the stock market experienced the volatility that is has experienced in the first few months of this year. From its peak on February 21 to its trough on March 23, the stock market experienced its fastest 33 percent decline on record. This was followed by a bounce of almost 30 percent, making April 2020 the stock market’s best month in many decades.

With the stock market’s strong April bounce coinciding with the onset of a very deep coronavirus-induced economic recession, Krugman suggests that a weak economy could in fact be good for U.S. stocks. The essence of his argument is that a weak economy has been associated with very low interest rates. With interest rates very low, he contends that investors have no alternative but to invest their money in the stock market. He seems to think that this is particularly the case today when interest rates on 10-year U.S. Treasury bonds are as low as 0.6 percent

The basic point that Krugman seems to be missing is that if the U.S. economy proves to be as weak for as prolonged a period as the U.S. Treasury market seems to be telling us that it will be, U.S. corporate profitability will be decimated, bankruptcies will soar and dividends will be slashed.

If that occurs, it will be inconsistent with the continued growth in corporate earnings and dividends that presently underly the stock market’s still lofty valuations. In time, that inconsistency is bound to cause a re-evaluation of stock market prices that can lead to large capital losses on one’s stock portfolio.

Needless to add, if there were to be a large correction in the U.S. stock market, contrary to what Krugman seems to be suggesting, investing in U.S. Treasuries even with their close-to-zero yields will have proved to be a wiser investment decision than buying overvalued equities on which one would be recording a large capital loss.

A more likely explanation than that of Krugman of the stock market’s strong April rally is that unlike the U.S. bond market, the stock market is expecting a V-shaped economic recovery once the coronavirus-induced lockdown of the U.S. economy is lifted. On this view, the sharp 30 percent sell-off in the stock market in the first three months of the year was excessive and April’s strong rebound was fully justified. 

Another plausible explanation of the market’s strong April rally might be the very rapid and bold response of the Federal Reserve to a deteriorating U.S. economic outlook. By cutting interest rates to their zero bound and committing to yet another round of large-scale bond buying, the Fed might have reconfirmed the stock market investor’s belief that the Fed has their backs covered. As has been the case on many previous occasions, investors might be entertaining the belief that no matter what happens to the U.S. economy, the Fed would be there to ride to the stock market’s rescue. 

Only time will tell whether it is the bond market or the stock market that will prove to have been correct in its assessment of the U.S. economic outlook. Will the bond market’s current pessimism be proved correct in believing that the U.S. economy will at best experience only a slow and protracted recovery from its worst economic recession in the post-war period? Or will the stock market be vindicated in its view that the Federal Reserve’s action coupled with a $2 trillion budget stimulus package will set the basis for a V-shaped economic recovery?

But even at this stage, we can be sure of one thing. Holding such divergent views, the stock market and the bond market cannot both be correct in their assessments of the U.S. economic outlook. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Tags #coronavirus #2019nCoV #contagion coronavirus Department of the Treasury Federal Reserve Finance international monetary fund Market trend Monetary policy Paul Krugman Recession Stock market

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