The US stock market is on a tear. Since the start of this year, January 2024, the Dow Jones , S&P 500, and NASDAQ have each repeatedly set new all-time records. Indeed, the trend in stocks has been strongly upward for the last two or three years. For instance, the S & P 500 is about 40 % above where it was in January 2021, when Joe Biden became President [43 % higher].
The price of gold has also shown a strong upward trend, reaching $2,470 an ounce on July 17, the highest in history. Why are these assets so elevated?
- The stock market and gold
An increase in perceptions of risk due to recent political and geopolitical uncertainty, could explain the rising gold price. But it cannot explain the stock market. Anyway, the VIX has been declining during this period, not rising. That could explain the stock market, but not the price of gold.
Prices for chip-maker Invidia and other high-tech stocks have risen the most rapidly and have gotten the most attention, particularly inspired by the rapid emergence of artificial intelligence since late 2022. But even the rest of the stock market, with tech companies excluded, has seen a steady rise in prices.
Prospects of an easier monetary policy in the future could, in principle, explain both the high stock market and the high gold price. It is well known that the stock market depends inversely on the interest rate, holding other things constant. One way to think about it is that an increase in the interest rate reduces the presented discounted value of future corporate earnings. (Another way to think about is that an increase in the interest rate induces investors to shift out of equities and into bonds.) Conversely, lower interest rates would explain the higher stock market.
The real price of gold also depends inversely on the real interest rate, both in theory and practice. Prospects of easier monetary policy should raise demand for gold.
But interest rates, including long-term rates, rose during this period, which works to lower stock prices and commodity prices, not to raise them. So, where should we look to explain recent financial markets, the rise in real interest rates that has taken place over the last two to three years, or the likely prospects of reductions in the near future? For an answer, let’s turn to the foreign exchange market.
- The foreign exchange market
The foreign exchange market provides the most convincing evidence that recent movements in financial markets have come at a time when monetary policy is, if anything, tighter than had been expected two or three years ago, not looser. The dollar is 14 % stronger than it was three years ago [=log 117/102, for the index of advanced-country currencies.]. If real interest rates during this period were low or expected to fall, the currency should be weaker, not stronger.
One explanation that has been given for the run-up in gold prices is that many countries are diversifying out of dollars and into gold. This is likely to be especially true of the People’s Bank of China and other central banks of countries that don’t have good geopolitical relations with the US (for example, as reflected in voting patterns in the UN) and thus may fear future sanctions. But, again, the foreign exchange value of the dollar should have been weakening, if that were the explanation, which it is not. Furthermore, recent econometric evidence shows surprisingly little support for the hypothesis that geopolitical disaffection vis-vis the US is driving the global shift out of dollars.
- GDP growth can explain it all
What can explain simultaneously high prices in all three markets, gold, stocks, and the dollar? The answer is strong demand for these three assets coming from a strong US real economy. Two or three years ago, professional forecasters as well as the general public thought there was a high chance of recession in the near future, if indeed the economy was not already in one. But, contrary to those expectations, real GDP over this period has continued to grow.
Admittedly, in the case of the price of gold, one should look at global growth, not US growth. (Growth in Europe and China has lagged; but the IMF says that global output gaps are now closing in these places.) US consumer demand has been strong. Growth in 2021 and 2022 was boosted by the CHIPS Act, Infrastructure Investment Act and the Inflation Reduction Act. Members of neither political party are prepared to reverse the fiscal expansion in order to confront the rising national debt. And a global safe-haven demand for US assets, so far, has continued as strong as ever.
True, US economic growth, registering 2.5 % in 2023, has slowed relative to the rapid pace of 2021. But it is still higher than has been usual so far this century. (The average GDP growth rate since 2001 was 2.0 %.) And, most relevant for asset prices during this period, economic activity has been stronger than had been expected at the beginning of Biden’s term. Not only was growth in 2021 unusually high, but observers’ forecasts that growth would disappear in 2022 and again in 2023 were repeatedly surprised on the upside. The advance GDP estimate for the 2nd quarter of 2024 last week came out, yet again, stronger than expected: a growth rate of 2.8 % per annum. Presumably, each time that economic activity was higher than expected, the demand for American stocks, gold, and the dollar rose. This would explain the upward trends in all three sorts of assets.
But prices are by now very high, particularly in the stock market. Whether this pattern of strength will continue after the November presidential election is anyone’s guess.
