After a disastrous year for global equities in 2022, so far, 2023 has been a tremendous year in terms of equity index returns. Let’s for example look at Nasdaq 100 – YTD return of +25%, and S&P 500 – YTD +9% (as of May 17).
In terms of global economic outlook, however, most people seem worried that some form of recession will soon arrive, perhaps within the next year. The reason for that is simple. Our economy’s growth or slowdown depends greatly on the amount of money and credit available.
Due to the highest level of inflation in more than 40 years that caught the world by shock and surprise, the single most important factor for economic growth – money & credit supply – has begun to tighten as the Fed started an aggressive rate hike phase.
Massive money party (2020 ~ 2021)
Since the aftermath of the financial crisis in 2009, and especially following the break-out of COVID-19 in 2020, the U.S. government and the Fed printed and distributed enormous amount of money, which were used for consumption as well as investments. To understand just how much new free money was created during the 2 years following the COVID-19 break-out, we can examine the growth of Fed balance sheet & M2 money supply.
From March 2020 to early 2022 – a 2-year period – the Fed’s total assets grew from $4 trillion to $9 trillion – an eye-popping $5 trillion increase. In 2020, the Fed’s total assets stood at $4 trillion. In less than 3 months from March 2020 to Jun 2020, it grew by $3 trillion to over $7 trillion. By early 2022, it reached almost $9 trillion. In less than 2 years, it grew by more than 110%. To put this in perspective, the amount of total assets that increased over 12 years following the great financial crisis of 2008 was $3 trillion (from $1 trillion to $4 trillion).
In addition, during the same 2-year period, U.S. M2 money supply has increased by a whopping $6 trillion to over $21 trillion. To put this amount in perspective, M2 increased about the same amount ($6~7 trillion) during the prior 10-years, from 2011 to 2020.
The biggest problem with such crazy amount of free money distribution was that, looking back now from hindsight, the economic fallout from COVID-19 was almost non-existent. Historically unprecedented amount of money was distributed out of fear of uncertainty over how much economic consequences the pandemic could bring. However, this turned out to be an enormous policy misstep.
The massively printed money was used by the people to go on massive spending spree and speculate big time on stocks, cryptocurrency, NFTs, re-sell goods, and many other things. During the post-COVID bubble, it was close to impossible to find someone that didn’t invest in stocks – everyone was talking about people quitting jobs and retiring through huge gains from stocks and coins.
With so much free money given to people by the government, such low-cost and easy-to-get loans, and such easy-gained profits from stocks and coins, the entire country was basking in extreme euphoria and spending spree, consequentially causing the highest levels of inflation in more than 40 years.
In addition to the misstep of excessive money printing, Fed made another significant misstep in starting tightening phase too late. Even with historic levels of inflation showing up in 2021, Powell and Yellen were baselessly confident that inflation was “transitory”. Fearing premature tightening would dent the economic growth coming out of the pandemic, the Fed delayed hiking rates until too late.
While we face great uncertainty going forward, I believe the consequences of excessive money printing and late tightening of the post-COVID boom will soon grasp the world with shock and their effects would likely be stupendous.
Historical cases of disastrous policy missteps
Historically, bubbles that lead to recessions have been triggered by major policy missteps, especially monetary easing decision timing error.
The Great Depression (1929)
The enormous stock market bubble that eventually led to The Great Depression of 1929 was triggered by a seemingly benign 50bp rate cut in July 1927 by the then Fed led by Benjamin Strong of the New York Fed – a decision made after a meeting with the central bank heads of the UK, France, and Germany in Long Island to support the value of plunging British Pound. This rate cut triggered a take-off in market euphoria from August 1927 until it all came down in October 1929.
Adolf Miller, a Fed board member from 1914 to 1936 testified in 1931 before Congress that ‘the easing of credit in the middle of 1927 was “the greatest and boldest operation ever undertaken by the Federal Reserve System, […] resulting in one of the most costly errors committed by it or any other banking system in the last years.”’ (Ahamed, Liaquat. “Un Petit Coup De Whiskey”. Lords of Finance: The Bankers Who Broke the World. Penguin Books. 2009, pp. 300.)
The bubble peak reached in 1929 was not reached again until 1954 – it took 25 years.
Japanese Asset Price Bubble Bust (1990~1992)
Some people say Japan’s lost decades resulted from the forced appreciation of the Yen during the Plaza Accord. In fact, Japan’s decades of deflationary period were the consequences of unprecedented bubble triggered by the Japanese government and BOJ’s policy misstep of excessive monetary easing policies.
Following the appreciation of the Yen in 1985 Plaza Accord, asset prices in Japan began soaring led by real estate prices. Strong yen gave the BOJ much leeway to aggressively ease its monetary policy, which in turn boosted liquidity, encouraged heavy credit and speculation, making the Japanese the richest on planet. Despite such strength in economic activity and fast appreciation of asset prices, the Japanese government was slow to tighten its policies. When it finally decided to tighten in 1989 with rate hike from 2.5% in April to 4.25% in December, it was too late. The bubble created in Japan’s assets from real estate to stocks was way too much and the sudden tightening ended the party with an infamously catastrophic consequences.
As William Quinn and John Turner elaborate in Boom and Bust: A Global History of Financial Bubbles (Cambridge University Press. 2020. pp. 143.), “Japanese land and stock bubbles were purely political creation. Not only did the Japanese government provide the spark, but it systematically cultivated all three sides of the bubble triangle [money/credit, marketability, speculation] with the explicit goal of generating a boom… By lowering interest rates, encouraging the extension of credit and creating the expectation of an appreciation of the yen, the government generated enormous amounts of fuel for speculative investment.”
As most of us know, the peak reached by Nikkei 225 in 1989 has still never been reached again in over 33 years.
Dot-Com Bubble Bust (2000~2002)
Likewise, the series of rate cuts following the panic of LTCM collapse triggered the massive one-year stock surge from late 1998 to early 2000 that all came crashing down from March 2000 to October 2002.
The high of 5049 reached by Nasdaq Composite Index on March 10, 2000 was not crossed again until April 2015 – more than 15 years later.
The first major tightening cycle since the 2008 Financial Crisis (2022~)
Most investors today probably don’t even remember the market environment where “quantitative easing” was non-existent.
In fact, except for the brief period in 2018 when the then relatively aggressive tightening by Jerome Powell caused the market to panic with a 20% drop in S&P 500 – making Powell immediately back down with an about face pivot – we have not experienced a single major tightening cycle since mid-2000s. The last recession we experienced was the great recession of 2008. Since then, we haven’t experienced any recession of the normal macroeconomic cycle. Powered by endless quantitative easing, most of today’s market participants have only experienced a stock market where stocks kept going up, with occasional corrections immediately followed by dovish pivot and thus turned out to be no-questions-needed buy the dip opportunity.
No wonder the market is worried about a possible coming recession in the face of the first major tightening cycle in their investing lifecycle.
Thus, we can acknowledge that the market is currently “too pessimistic” in that most investors are acknowledging that some form of recession could arrive for the first time since 2008.
Considering the current situation the market is facing, not acknowledging such a possibility is like running around blind-folded on a freeway at night and expecting nothing bad could happen.
So yes, the market should acknowledge the possibility of some form of recession in coming months.
Surprisingly resilient economy & stocks (2023 YTD as of May 22)
However, after initial panic response in 2022 by the stock market to high inflation and aggressive rate hikes, 2023 has up to now been dominated by hopes stabilizing inflation and potential pivot to rate pause and then cuts by the Fed.
Even with multiple bank failures including failures of Silicon Valley Bank and Credit Suisse in March, stocks barely budged. Immediate protective measures led by the government and the central banks actually boosted market confidence that any future failures will be backstopped.
More recently, even as we are less than 2 weeks away from the X-date when the U.S. government will default on its payments, the stocks have continued their ascent with the S&P 500 Index reaching a 9-month high. While acknowledging the possibility of the U.S. debt default, the market is confident that a deal will be ultimately reached.
Current market participants, while acknowledging that some things could break as interest rate rose from 0% to 5% in just a year, at the same time seems to believe that even if some things break, nothing truly bad will actually happen.
Market participants seem to be expecting the best of all worlds amid so many unprecedented uncertainties. Citing still strong economic indicators such as the unemployment rate, the market is confident that our economy is strong. Citing some softening indicators such as headline CPI, it is relieved that the Fed’s rate hikes are working effectively and begins expecting that the Fed will soon pivot. Encountering some bad news such as bank collapses, the market comes up with hopeful reasons to believe they will likely be contained and thus not lead to disastrous recession, while simultaneously citing just the right amount of negativity from the news to warrant expectation of a Fed pivot to rate cuts.
In short, the market (with support from Powell himself) is expecting a “soft landing” – a stabilization of inflated prices without triggering a recession. What the market really means by the “mild recession” it is expecting is a “transition to goldilocks without any negative consequences”.
Sadly, following a period of such excessive bubble, soft landing has never occurred. Some cite the so-called soft landing of 1994 led by Greenspan as a possible end-result of the current market cycle, but that period is probably more comparable to the very short-lived tightening cycle of 2018, when a brief panic reaction from the stock market was enough to scare Powell into immediately pivoting to rate cuts and restarted a goldilocks economy. Can we call this a soft landing? Not really. There was no landing to really worry about in the first place. In 1994 and 2018, there was no noticeable “insanity” in the stock market as was seen during dot com bubble of 2000 or the post-COVID tech bubble of 2021.
Considering the degree of speculation and bubble created during the post-COVID boom, the degree of money printed, the degree of inflation begotten, the aggressiveness of the delayed series of rate hikes implemented as a result of the bubble, I will not bet my money on the probability that the economy will come out of all this unscathed and magically transition to another goldilocks economy. That probability seems just way too low to me.
The market currently seems way too optimistic in hopes of a soft landing amid so many factors that historically have led to disastrous consequences.
A stunning similarity to the dot-com bubble & bust period Recently, I took some time to research and read through news articles during the dot com bubble bust period (early 2000 ~ end of 2002). The similarity of the overall tone of the market, major market movers, the key factors discussed, the actions and statements made by the Fed and the government during that period to the current market environment is quite stunning.
Let’s take a look at the Nasdaq Composite Index and key timeline events during the dot-com bubble era:
Now, take a look at the chart below of Nasdaq Composite Index in the current market:
Let’s take a look one more time at the chart of Nasdaq Composite Index during the dot-com bubble period, up to September, 2000 – prior to the beginning of major collapse:
What do you notice?
The yellow circled area in each chart pertains to the period following initial ~40% correction from the bubble high, where stocks made a noticeable rebound of ~30% from the recent correction bottom and recorded a sustained rally. The rationale in both cases: some softening data amid still resilient overall economy increased confidence that the Fed’s rate hikes are proving effective, creating expectations for Fed pivot and increasing hopes of soft landing.
In the case of Nasdaq during the dot-com bubble era, the yellow circled period was followed by a 2-year market collapse that concluded with a 78% drop from the bubble peak.
In the case of Nasdaq of the current market cycle, what is to follow the yellow circled period is of everyone’s focus.
To me, the overall market environment including the things that happened leading up to now and the things that are happening at the current moment seems stunningly similar to that of the dot-com bubble period.
Taking into consideration the degree of speculation and bubble created during the post-COVID boom, the degree of money printed, the degree of national debt, the degree of inflation begotten, the aggressiveness of the delayed series of rate hikes implemented as a result of the bubble, and the various signs and factors that historically lead to hard recessions such as yield curve inversion – which this time is the deepest ever in history, not to mention one of the most uncertain geopolitical environment amid Russia-Ukraine war and U.S.-China tension, I would like to bet money on the probability that the regional bank failures of March was just the tip of the iceberg in what is to unfold in the months ahead of us.
What about such a resilient economy and still abundant piles of cash?
The latest unemployment rate stands at 3.4% (as of April, 2023). This is the lowest level since 1953 and implies the fullest employment an economy can possibly have.
In addition, many asset managers cite the abundant piles of cash still waiting to be deployed – perhaps the biggest in history in sheer amount – as another sign that our economy is in a very strong position and thus recession is not likely.
Let’s take a look at historical unemployment rate data since 1948:
We can all clearly see recessions (the vertical greyed area) have always come when the unemployment rate was the lowest in the respective cycle. Low unemployment rate and strong employment fundamentals doesn’t mean recession will not come. In fact, strong employment and economy is what leads to tightening policies, and the effects from such tightening will take its lagging trait to suddenly take the markets by shock and consequentially bring recession.
What about the piles of cash?
We have discussed in great detail above on just how much money was created post-COVID 19. No wonder there is still so much money lying around, especially when the economy is still strong and stocks haven’t fallen much from the bubble peak, which means value of many people’s assets are still pretty much elevated.
One of the most important factors that lead to stocks rising and falling is the degree of wealth effect. When the value of stock investments rise, most people feel richer, and this in turn affects the level of spending and consumption a great deal. Especially when many people were quitting jobs amid such strong stock and coin markets post-pandemic, the gains from investments contributed greatly to the strong consumption, leading to such a strong economy. When people believe stocks will continue to go up – as was the case throughout 2021 – unrealized investment gains will be enough to warrant feeling rich and increasing spending. Such increased spending through the so-called “wealth effect” is essentially increasing debt deployed on risky assets, which can ultimately come to bite on the economy’s fundamentals in the form of debt defaults.
So, given the $5 trillion increase in Fed’s assets in less than 2 years, it’s a no-brainer that we still have so much cash, especially since the effects of interest rate hikes haven’t yet arrived, and the value of many assets that have led to great increase in wealth effect – notably stocks and home prices – remain elevated.
Will the piles of cash “waiting to be deployed” really be deployed with confidence as soon as serious recession takes toll? Or will it be more likely to stay in safe-haven until the market becomes more confident that the bottom has been reached? History seems to give much higher odds on the latter possibility.
What will unfold in the months (or years) ahead?
No one can know exactly how things will unfold. But based on the facts and data, and learning from history, it is very likely that the lagging-effects of one of the most aggressive rate hikes in modern financial history will soon take a toll on the economy. Credit will tighten, default rates will rise, consumption will fall, corporate profits will fall, which would render current stock valuations way too expensive. But with recent memory of excessive QE post-COVID causing historic inflation, how aggressively would the Fed be able to pivot and cut and ease in the face of recession unfolding? That could be one of the biggest risks for stocks going forward.
As Mr. Powell thought the inflation was transitory and have failed to foresee SVB and other regional bank failures despite constant reassurances of the soundness of the U.S. bank fundamentals, he will likely be wrong again in his confidence that a soft landing is likely. Greenspan was wrong following the dot-com bubble. Bernanke was wrong leading up to the great financial crisis. I hope Powell is right for the first time ever, but honestly, I don’t think it is very likely.
Investors should invest based on objective assessment of the odds of various possibilities. The current market seems to be betting too optimistically on a possibility with odds so little, because that is what it wishes to happen. Don’t invest on wishes. Invest on good odds.
Thus, I would refrain from riding on the current market rally as the odds of an economic fallout unfolding and stocks collapsing from the current high valuations seem much higher than the odds of Mr. Powell successfully orchestrating a first-time-ever soft landing in one of the most uncertain market environments in modern financial history.
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