Markets may be in store for additional pain
Publishing date:
Jul 19, 2022 • 14 hours ago • 4 minute read • 5 Comments
The Federal Reserve building in Washington. Photo by REUTERS/Kevin Lamarque/File Photo One of the single largest contributors to booms and busts is the tendency of investors to suffer periodic bouts of long-term memory loss. During such episodes, people view recent market dynamics as being normal, regardless of whether such behaviour is an aberration from a long-term historical perspective.
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It is difficult to understate the degree to which the economic and investment climate that has prevailed since the financial crisis of 2008 and 2009 has deviated from its long-term historical norm. It is challenging to identify any other time in history when financial markets have been as influenced by ultra-low interest rates and vast amounts of fiscal stimulus as they have been over the past decade.
Given the powerful wind of governments and central banks at their back, the best strategies for investors have been: buy anything from stocks to real estate to art; buy even more of it during dips, which consistently proved to be good buying opportunities; use maximum leverage to turbocharge buying power and returns.
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The Phillips curve is an economic concept developed by A. W. Phillips that describes the relationship between inflation and unemployment. The theory holds that there is an inverse trade-off between the two variables. All else equal, lower unemployment leads to higher inflation, while higher unemployment is associated with lower inflation.
Phillip’s theory proved resilient for most of the postwar era. One notable exception occurred in the early 1970s, when the Organization of the Petroleum Exporting Countries (OPEC) issued an embargo against Western countries, resulting in stagflation (both high inflation and high unemployment). The second aberration covers the time between the 2008 financial crisis and mid-2021.
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The inflation genie has been dormant. It had calmly remained in its bottle in the face of monetary and fiscal conditions that in times past would have caused it to bust out full of fire and brimstone. The combination of low unemployment and tame inflation provided a goldilocks backdrop for corporate profits and asset prices. But, to steal the tagline from Jaws 2, “Just when you thought it was safe to go back in the water,” inflation has returned, prompting central banks to slam on the brakes. This has changed the landscape in ways that have, and will continue to have, far-reaching implications for investors’ portfolios.
The law of supply and demand can vary in terms of timing, but it cannot be eradicated. You can either eat your entire cake all at once or piece by piece over time. You can’t do both. The free-money, one-way asset prices, all-you-can-eat risk party that has been raging since 2008 has given way to today’s hangover of rising inflation, higher interest rates, falling stock prices and risk aversion.
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The question is whether the current market malaise is merely a garden variety hangover, or a case of alcohol poisoning. The answer might come from Japan.
Without a doubt, there are vast structural, economic, demographic and political differences between Western economies and that of Japan. Nonetheless, the Japanese experience serves as a warning of the potential consequences when extreme levels of monetary stimulus are applied for an extended period.
Following the collapse of the most severe stock-market and real-estate bubbles in modern history, the Bank of Japan pioneered many of the policies that have become commonplace among central banks. In 2000, the Bank of Japan cut interest rates to zero, and in 2001 it became the first central bank to engage in quantitative easing.
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Since then, Japan has become so hopelessly addicted to nearly unlimited free money that it is unable to function without it. In 2006, the Bank of Japan enacted a small interest-rate hike, which resulted in a significant hit to business confidence and investment. As a result, it was forced to bring borrowing costs back down to zero. For more than 20 years, the Bank of Japan has been unable to detox the Japanese economy and wean it off the monetary “sauce,” continuing to apply copious doses of stimulus year after year.
Notwithstanding the current decline in markets, recent history suggests that markets remain highly vulnerable as central banks continue to take away the punch bowl.
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Article content At the end of 2015, after leaving short-term rates at zero for about seven years, the United States Federal Reserve began raising its benchmark rate, taking it up to 2.5 per cent by late 2018. Despite still being low by historical standards, this level caused a slowdown in economic activity and a peak-to-trough decline of 19.3 per cent in the S&P 500 Index during the fourth quarter of that year.
In response, the Fed pulled an abrupt U-turn and cut rates back to 1.75 per cent in less than a year before slashing them back to zero in response to the COVID-19 crash.
This episode illustrates the degree to which economies and markets the world over have become addicted to monetary stimulus. It also suggests that leaving rates below the level of inflation for more than a decade has placed markets in a heightened state of fragility.
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Article content There is an ominous distinction between the debacle of 2018 and the current bout of market volatility. In the former case, inflation was well contained, which gave the Fed the latitude to cut rates, stave off an economic slowdown and spur a recovery in stock prices.
With inflation currently running well above target, central banks are boxed in. Should growth begin to falter while inflation remains elevated, they may be reluctant to turn on the spigots and save the day. I am not saying that the “Fed put” no longer exists, but rather that it is far more out of the money than has historically been the case. This suggests that markets may be in store for additional pain.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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