Investors May Cause the Economy to Fulfill Their Beliefs

There is no hiding that it has been a rough few months for markets around the world. The S&P 500 is down 2.8% for the year as of Friday close, risking to put the index in the red for the year for the first time since 2015. The NASDAQ and Dow are feeling the same downward pressures. Major European indexes are in bear territory.

These declines are coming in a large part from investors’ being anxious about the global economy. With uncertainty surrounding trade, slumping growth abroad, and rising home interest rates all happening at once, investors are growing wary of where the market is going.

This has led to roughly 49% of investors believing that stocks will be lower in six months’ time, according to the American Association of Individual Investors’ most recent survey.

People should be cautious though: self-fulfillment of beliefs can easily occur. If everyone believes a downturn is coming, the shared belief may be what causes the downturn to start.

An Aside on Self-Fulfillment

Self-fulfillment is the idea that markets and the general economy can move in the direction of where everyone believes it will go.

Confidence is an important shift variable for both consumption and investment. When consumers and businesses lack confidence in the economy, they spend less so they can save money for when they need it in a downturn. If everyone is confident and sees future growth, everyone puts money into the economy and growth will occur.

A good example of self-fulfillment happened in the early 1990’s, prior to the formation of the euro. Back then, Europe had a pegged currency system where major European economies, including the United Kingdom, had their currencies pegged to the German mark. Pegs are an economic instrument that require confidence from the public. If no one believes the peg is credible, then it will have a harder time existing.

In 1992, the U.K.’s peg to the mark was threatened due to Germany’s rising government spending and interest rates (they were bailing out the former East Germany). In order for the peg to hold, the Bank of England had to also raise interest rates, causing loans to cost more. This increased costs to businesses as well as consumers trying to buy homes and cars, leading to decreases in spending.

Now enter investor George Soros. He saw these rising interest costs as a precursor to the peg breaking. He saw through the Bank of England’s monetary support of the peg and began betting that it would break. Other investors followed suit and began placing bets on the peg breaking. The shift in beliefs caused significant downward pressures on the pound, and overnight, confidence disappeared.

The peg broke on September 16, 1992, one day after Soros placed his bet.

(This date became known as “Black Wednesday.” This is a story in of itself and can be read more in depth here.)

Back to the U.S.

Black Wednesday is a special case, but still demonstrates self-fulfillment: Without Soros’ bet, investors would not have had a change in sentiment, and the peg would have lasted longer than it did. It broke on September 16, 1992 due to everyone believing that it was going to break.

Now lets look at the U.S.: Unemployment is at a multi-decades low of 3.7%. Businesses are continuing a recent upward trend in borrowing. States are seeing strong revenues allowing for much needed infrastructure spending. Even with trade tensions and slowing economies elsewhere in the world, the data from the U.S. is still strong in many areas.

A recession will inevitably happen eventually, but anxious investors may fulfill their beliefs and cause one to happen sooner than it would otherwise. If the sell off of the past few months continues, consumers may lose confidence in the economy and spend less. Businesses may take out less loans out of fear of lower revenues. States may sock more revenues into a rainy day fund to support themselves in a recession rather than continue their current infrastructure spending.

This would all culminate in a slowdown induced by fear and not a slew of poor data.

None of this may actually happen in the near future. But fear spreads quickly, and a lack of confidence in the economy can really pull back growth. The stock market is a highly visible entity, and negative swings always cause fear in people (not the 401K!). If investors keep pulling out of the market, the fear can spread through the economy, leading to lower confidence and an expedited recession.

A less anxious view of the economy and a leveled off stock market can help keep consumer and business confidence strong, helping to keep the economy chugging.

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