New paradigm means markets may fall with the economy as stimulus runs out

To most people, it may seemlogicalthat stock markets rise and fall with economic growth.But forthe last decade or more, that has been anything but true.

As the value of assetslike stocks, bonds and houseshas continued to climb, the growth of variables like wages and production has nowhere near kept up.

"The stock market can be relatively divorced from thereal economy as measured in terms of GDP for significant periods of time," said GurupdeshPandher, a specialist in finance who has worked in the private sector and in academia.

As Canadians try to understand how 2023 will unfold for investors, for homeownersand for wage earners struggling to keep their heads above water, Pandher's message is that the previous15 years when asset values have persistently outpaced the economy may be a poor guideto the immediate future.

New financial paradigm

In the very long term, history shows that asset values do track the economy, but for lengthy stretches,including the last decade or so, thatrelationship can get very much out of sync. And now, after years of what seemed like proof positivethat asset prices had nowhere to go but up, suddenly the rules have changed.

As one finance specialist told me, newer investors whose experience of the last decade had taught them that the stock market was an easy money-spinnerwere being forced to rethink. Many are now looking for someone or somethingblame, but the truth is that economic and financial cycles, while inevitable, are complicated.

The essence of the problem, say many analysts, is that after years of struggling to boost an economy and a job market that seemed too cool, governments and central banks are suddenly being forced to deal with an economy that they fear has grown too hot.

Friday's jobs data, especially in the U.S, is expected to show a persistent shortage of workers. Newly released minutes of the committee that guides interest-rate decisions at the Federal Reserve revealed worries about continued strong employment and a fear that financial markets are still too optimistic suggesting central banks have not finished raising interest rates.

As Pandher, now professor of finance at Windsor'sOdette School of Business, explained it, ever since the fallout from the economic crisis of 2007 and 2008, when a U.S. real estate bubble popped and led to a banking crisis, governments and central banks have been laying on the stimulus. In the past, economists might have expected years of low interest rates, tax cuts and high government spending to have launched a round of wage and price increases.

But for reasons that include a surge in production from elsewhere in the world, notably China, businesses were constrained from raising prices and workers from demanding higher wages. With inflation refusing to budge, market signals became confused. Repeatedly we saw thatgloomy economic signals, perversely, led to asset price increasesas traders anticipated more and continued economic stimulus.

That process extended into the 2020s asgovernments struggled to save the world from a COVID-led economic collapse.

Not just stocks but property too

A graph of stock prices against economic growth, seen above, shows a long upward trend since the beginning of 2009 as asset prices almost continuously grew much faster than the underlying economy only interrupted last year after interest rates began to rise.Canadian house prices, never really hit by the U.S. property crash, did something similar.

Even as tax cuts were promoted as a boost for main street ("It will be rocket fuel for our economy," Trump promised at the time)later economic analysis showed that the principaleffect was to boost asset prices.

As Pandher explained, the phenomenon did notjust apply to stocks. He said 15 years of excess liquidity in other words lots of cheap money seeped into all asset markets. For Canadians, the obvious asset to outpace incomes and the wider economy has been house prices. And cheap money, intended to allow companies to invest in expansion of their businesses was often redirected to share buybacks that again stimulated the market more than the economy.

"The cost of borrowing for companies came down sothey could borrow money for stock purchases," said Pandher. "The same thing for households. They could invest in additional real estate, buy a second home, or buy another car as financing became cheaper."

Riding to the rescue

Some trace the use oflow rates and high government debt as a tonic for weak growth and struggling markets back to former Fed chair Alan Greenspan, who has beendescribed as"extremely proactive in halting excessive stock market declines."

For years, low and stable wages and moderate price rises made that possible. But under the new paradigm of tight money and inflation-fighting, everything changed,and for many that may come as a shock.

"Financial markets in particular get conditioned to this world whereevery time something goes wrong, a central bank comes riding to the rescue," said markets analystTommy Stubbington in a slightly frightening Financial Times documentary looking ahead to 2023.

As Stubbington, Pandherand many others have observed, oncean economy becomes overheated, cuttinginterest rates, buying up government debt with quantitative easingand distributing unfunded government stimulusspending only makeinflation worse.

"You can no longer buy up government debt every time there's a wobble in the markets because you need to concentrate on your main mission which is fighting inflation," said Stubbington in the FT video.

Of course the long period of low interest rates has not been the only economic forceimplicated in surging inflation, saidAndriy Shkilko, professor of finance and Canada Research Chair in Financial Markets at Wilfrid LaurierUniversity in Waterloo, Ont.. Supply chain problems that cut off imports, the effects of the Russian invasion of Ukraine and the sudden demand for goods rather than services when COVID-19 hit all helped push up prices.

Expect booms and busts

Booms and busts in the economy and in financial markets are completely normal, said Shkilko, which may have come as ashock to new investorsor those who hadforgotten.

"Most of the younger generation has not seen this before and I can even see that in mystudents because in the last 10 years, they all thought of themselves as these brilliant investors because they made money in their little investment accounts," Shkilkosaid.

He is one of those who recommends investors hang tight and not panic.

"The way to get rich and not to lose sleep is to just steadily put money into the market and wait for retirement," said Shkilko. "If you look at the long term trend, markets have always been going up because the economy is growing."

But if, over the very long term, markets really dotrack the economy, it may be reasonable to ask whether a long and strong rise in valuations above economicgrowth must inevitably and eventually lead to the opposite.