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

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

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

"The stock market can be relatively divorced from the real economy as measured in terms of GDP for significant periods of time," said Gurupdesh Pandher, 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 homeowners and for wage earners struggling to keep their heads above water, Pandher's message is that the previous 15 years — when asset values have persistently outpaced the economy — may be a poor guide to the immediate future.

In the very long term, history shows that asset values do track the economy, but for lengthy stretches, including the last decade or so, that relationship can get very much out of sync. And now, after years of what seemed like proof positive that 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-spinner were being forced to rethink. Many are now looking for someone or something blame, 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's Odette 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 that gloomy economic signals, perversely, led to asset price increases as traders anticipated more and continued economic stimulus.

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

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 principal effect was to boost asset prices.

As Pandher explained, the phenomenon did not just 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.