Every once in a while, we hear the stock market is falling because the dollar is falling, or the falling stock market will lead to a falling dollar, or rising currencies and rising stock markets elsewhere will lead to the dollar and U.S. stock market falling together.
You’d think that the linkage between two important asset classes such as currencies and stock markets would be straightforward, but it’s not. For one thing, both markets respond to many economic factors the same way, which is not to say a move in one causes the same move in the other. But they don’t move in sync on every factor. A rise in inflation and inflation expectations that is serious enough to trigger talk of rate hikes is currencyfavorable but stock market-negative.
A stock-market crisis exacerbates existing confusion. A stock-market crisis usually causes safe-haven flows into fixed income notes and bonds, driving the price down and the yield up. A rising yield favors the currency, but so does the knee-jerk flow out of the crisis currency into a safe-haven currency. If a crisis in a foreign stock market causes a safe-haven flow into U.S. fixed income, by definition it’s also a flow into U.S. dollars. You’d have to be a forensic accountant to figure out how much flight capital goes into notes and bonds and how much goes into plain old dollar cash accounts.
In short, it’s very, very difficult to untangle the relationship between currencies and stock markets. Even the most plausible-sounding press reports are simply not to be trusted. The current version of the currency-stock market story has it that:
• The U.S. dollar has been falling against the benchmark euro since October 2000, siphoning capital away from U.S. stocks.
• Returns to investors are unfairly distributed to dollarholders: Since the dollar started falling in 2000, the MSCI World ex USA index has gained 32 percent in dollar terms but lost 19.2 percent in euro terms. The MSCI U.S. index is up 7 percent in dollars and down 35 percent in euros. This imbalance should be rectified.
It’s an industry joke that the word “should” should always be put in quotation marks when used in a financial context — and often in economics, too. To say that some event should occur to achieve fairness is to dream of a world that does not exist and never did. Financial market outcomes aren’t always fair, and unfair situations persist for long periods. Sometimes a disequilibrium delivers a comeuppance to some party we dislike, but it’s not realistic to count on it.
To look at the U.S. dollar and stock markets, let’s start with the Chinese shock. Twice in the past three months, the Shanghai Composite Index (SCI) has tanked. Critics of the Chinese stock market rudely say it is little more than a gambling den — a stock listed on it goes up even when a company reports bad earnings, or fails to report at all.
The Japanese equivalent of the Wall Street Journal, the Nihon Keizai Shimbun, reports that some Japanese speculators are playing the Chinese stock market but should be worried about the Chinese bubble bursting. On April 19, the SCI fell 250 points on rumors of central bank tightening, but recovered all of it the next day to set a new record — definitely bubble behavior. “There were more than 90 million stock trading accounts held by individuals in China as of [April 19],” the Nihon Keizai Shimbun wrote. “This means that, in theory, one in six urban dwellers is trading stocks.
” Earlier, on Feb. 27, when the Shanghai composite index fell by a dramatic 8.8 percent, stock indices around the world followed suit. In the U.S., a computer glitch added to the sense of panic. The Dow crashed some 500 points as the ticker failed to keep up with trades, and closed the day down 416.02 points, the biggest oneday point decline since Sept. 17, 2001 (the day the market reopened after 9/11). The S&P 500 also closed down 3.47 percent, with the Nasdaq down 4 percent. As it happened, European bourses were closed that day, but emerging markets such as Russia, Turkey, and Brazil all posted big losses.
It took until April 13 for the S&P to get back to where it had been before Feb. 27 — just in time for the next Shanghai surprise. After this event, though, the American indices barely burped.
U.S. stock markets are probably not at risk from a global panic arising in China. This is not so much because U.S. stock valuations are based on things such as price-earnings ratios, sober estimates of future earnings, and the excellence of management, but because a bubble in China is pretty much contained to China. Yes, there is foreign participation, but selling here to make up for losses there is likely to be small potatoes, if only because hardly any Chinese are able to invest outside of China.
Besides, Western professionals know full well that Chinese stock prices are divorced from reality. We have to assume those professionals prudently allocate less than they might given the size of the Chinese economy. Also, the supply situation is just plain weird, with the government owning most companies and able to add to or withdraw supply arbitrarily. That has to make Western professional managers warier than they are in a truly free market.
Still, we need to keep an eye on any stock market that is overpriced on unrealistic expectations and irrational exuberance. Cross-border stock market contamination is always possible because of the fear factor.
The U.S. stock markets are more deeply vulnerable to another danger — that foreigners increasingly shun U.S. equities as already fully valued, whereas other markets offer opportunities. The German DAX index, for example, is up by triple the amount of the S&P 500 since the beginning of the year, and more than double over the past two years (Table 1). Over those two years, if you were a dollar-based investor, you got an additional 5.25 percent from being in the euro, which rose from 1.2885 to 1.3562 over the period.
On the whole, we are accustomed to an environment in which the U.S. stock market leads the world. The correlation of other stock markets with the U.S. is quite remarkable, especially if you consider stock valuations “should” be based on earnings and other fundamentals. Why would a bounce in a U.S. index be mirrored in some other country’s index, where earnings and other fundamentals are different — and not even reported on the same schedule?
It shows the DAX and the S&P 500, converted to show the percentage changes over the past 500 days. The two indices move in lockstep.
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