[Lee Jong-woo's Economic Insights] Impact of Tightening and Economic Slowdown... Global Stock Markets Fluctuate

Increased Anxiety Over Stock Price Volatility
Growth Rate Outlook Positive but
Impact of Corona Economy Growing

Both Short- and Long-Term Interest Rates Rising
Higher Possibility of Tightening
Likely to Remain Weak for the Time Being

Global stock markets are shaking. The KOSPI is in a state where it is difficult to gauge the bottom, and the US market is also struggling, falling sharply even with minor negative news. The content is also problematic. Since January, the pace of decline has suddenly accelerated, and stock price volatility has increased, intensifying anxiety.

The recent sharp decline in stock prices is due to tightening and economic slowdown.

Currently, the prevailing forecast is that the domestic and international economies will be favorable this year. Growth rate forecasts are around 3% domestically and up to 4% in the US and Europe. The problem is reality. In the third quarter of last year, the OECD Leading Economic Index peaked. This indicates that the economic recovery after the COVID-19 outbreak has begun to weaken, and considering the reduction in fiscal spending in developed countries and the shrinking household consumption capacity, the economic slowdown trend is likely to strengthen over time.

This situation was somewhat anticipated. This year, US fiscal spending will decrease by more than 20% compared to last year, weakening the government's role in the economy. To maintain stable growth under these conditions, securing consumption capacity and price stability are necessary. Many households in various countries still hold the money distributed by the government during the COVID-19 recovery process, but high prices are preventing a significant increase in consumption.

COVID-19 is also a problem. The spread of COVID-19 in developed countries, including the US, is considerable. In the US, there are daily new confirmed cases of 800,000, and in major European countries, nearly 300,000 new cases are reported. This is more than double the peak spread last year, showing how severe the current COVID-19 situation is. Although the economic sensitivity to COVID-19 has decreased due to the expansion of online consumption and the establishment of remote work infrastructure, the impact has not completely disappeared. As new COVID-19 cases increase, isolation increases, and the working population decreases, potentially leading to economic contraction. China is a representative example. With stricter movement restrictions, negative effects are expected to gradually appear.

Even if economic activity slows due to COVID-19, there are no cards left to play. Since the policy has already shifted to tightening, it is difficult to lower interest rates again. Liquidity supply is also not easy. Considering that the domestic economy entered an upward trend from the fourth quarter of 2020, a cyclical slowdown is likely to begin soon. The COVID-19 spread coinciding with this phase is increasing its impact on the economy.

If this year's economic forecast is accurate, there will be no problem, but if not, it will cause significant damage to stock prices. Disappointment doubles when expectations of a good economy turn bad. If the economy is good, raising interest rates is not a problem because the influence of economic recovery outweighs the impact of interest rate hikes. Conversely, if the economy is poor and interest rates rise, the burden doubles.

Another factor pressuring the market is tightening. At the January Federal Open Market Committee (FOMC) meeting, the Federal Reserve mentioned raising interest rates in March. As the rate hike comes into view, the US 2-year Treasury yield rose to 1.15%. It was 0.17% in August last year, meaning it increased 6.8 times in six months. As a result, the long-term 10-year Treasury yield also rose to the mid-1.8% range. Over the past five years, US interest rates have moved only on one side, either short-term or long-term. Early last year, long-term rates rose while short-term rates remained quiet, and in the second half, short-term rates rose but long-term rates fell. This time, both long-term and short-term rates are rising, indicating a higher likelihood of tightening.

Since 2015, when the US benchmark interest rate was 0.5%, the 10-year Treasury yield averaged 1.82%. Currently, the US market interest rate reflects the Federal Reserve's one rate hike. When the benchmark rate was 1.0% and 2.0%, the 10-year yields were 2.31% and 2.57%, respectively. The market expects the Fed to raise rates three times this year to 1%, and next year to 2%. Since more than six rate hikes are expected, market interest rates may rise further.

The rate hike is not the end. At the January FOMC, the Fed mentioned starting liquidity reduction after raising rates. According to this, tapering will end in March, rate hikes will occur simultaneously, and liquidity reduction will begin as early as the second quarter or at the latest the third quarter.

The Fed first raised rates in December 2015 after lowering them during the financial crisis. After the third rate hike in March 2017, discussions on liquidity reduction began, and after the fourth hike in September 2017, liquidity absorption was formalized. Liquidity reduction started 1 year and 9 months after the first rate hike. This time, liquidity reduction is expected to start 3 to 6 months after the first rate hike, indicating a faster shift to tightening than expected.

The market was worried that the Fed would do nothing when conditions were good and then abruptly change policy at the last minute. Such a scenario would increase policy uncertainty and shock the market, and this is actually happening.

The appropriate stock price varies depending on the situation. The level of the price-to-earnings ratio (PER), which indicates the stock price relative to net earnings, differs when the Fed is injecting money versus withdrawing it. When money is injected, the PER rises, but when money is withdrawn, the ratio falls. This reflects the impact of liquidity on stock prices.

The PER of the US benchmark index, the Standard & Poor's (S&P) 500, has risen to 30 times, significantly higher than the 20-year average. The only time the PER was higher was just before the IT bubble burst. Since the situation is changing significantly and a reevaluation of appropriate stock prices is underway, it is highly likely that domestic and international stock markets will remain weak for some time.

The impact of tightening and economic slowdown on asset markets does not weaken over time. The only solution is for stock prices to fall to appropriate levels. Fortunately, if economic expansion continues or inflation decreases, reducing pressure for rate hikes, the time when stock price declines stop will come sooner, but it is unknown when that will be.