Yes: the recent small rise in yields in long-term government bonds could go further. As the OECD states in its Interim Economic Outlook: “Global economic prospects have improved markedly in recent months, helped by the gradual deployment of effective vaccines, announcements of additional fiscal support in some countries, and signs that economies are coping better with measures to suppress the virus.”
This is good news. But if, as a result, monetary policy tightened sooner and yields rose more than generally expected, that good news might be bad for markets.
Yet, even if a market correction hurt investors, would it matter that much for the economy as a whole? As the late Paul Samuelson asserted: “The stock market has forecast nine of the last five recessions.”
Still less do market corrections imply economic depressions. A sharemarket crash would only devastate the economy if policymakers let it do so – as after the crash of 1929. The results then were so dire only because the policymakers’ response was so foolish.
There are two ways in which a big sharemarket correction of the kind Grantham expects might be linked to a significant economic crisis.
The first is if it is a big enough shock on its own to cause economic meltdown. This is very unlikely: the wealth effects of falling sharemarkets on spending are real but modest.
The second is if the crash is part of an inflationary surge of the kind seen in the 1970s, or of a financial crisis triggered by waves of bankruptcy and the failure of financial institutions, as happened in the 1930s and threatened to recur in 2008. Neither can be ruled out entirely.
The economic recovery from COVID-19 may prove far stronger, and the consequences for price and wage inflation more powerful, than conventional wisdom expects. This is a bigger risk now than in the aftermath of the 2008 financial crisis. Yet it is still a modest one.
Stress tests by central banks and the IMF on core financial institutions indicate that they are robust. But there are other possible channels for financial disarray. One is the high levels of indebtedness in non-financial corporate sectors of high-income countries; another is the exposure of borrowers outside the US to shocks to dollar funding.
The combination of a huge US fiscal loosening with sharper than expected monetary tightening might destabilise emerging economies. This happened before, notably in the 1980s debt crisis.
In brief, a sharemarket correction is possible as COVID-19 comes under control, economies normalise and interest rates rise. But, in itself, this is not something to worry about much, especially as the effects of a stronger than expected economy versus higher than expected interest rates should offset each other.
Far more serious would be a debt crisis that damages core institutions, freezes markets and creates mass bankruptcies. Happily, this looks containable, given the tools available to policymakers. Still, unexpectedly high inflation and interest rates…