Rolling Bubbles and the US Recession

Fiscal and Monetary Policy Backdrop

Over the past 40 years, the US economy and much of the world economy has experienced a deflationary regime due to globalization and technology. This enabled the Federal Reserve to ease monetary policy - or lower interest rates and inject liquidity - whenever the economy was heading toward rocky shoals.

• Lower interest rates → lower cost of capital → incentivizes businesses and individuals to borrow and spend → economic growth

Since the federal funds rate peaked near 20% in 1980, rates have marched steadily lower until they flatlined near 0% during the pandemic and went negative in Europe and Japan. Imagine going to the bank and getting a loan that guarantees you pay back less than you borrowed?

The economic cycle is like a pendulum - swinging between contraction and expansion. A deflationary backdrop permits policymakers to bend policy and manipulate its cyclical rhythm during contraction to soften the negative economic effects.

But decisionmakers are often behind the ball. Policy changes experience time lags before they become imbedded in the economy. Sometimes policymakers over-stimulate the economy when it’s in a natural expansion. Other times, they slam on the breaks when the cycle is about to roll over - in effect, accentuating the directionality of the pendulum. Accommodative policy, in conjunction with the behavioral aspects of herd mentality and the fear of missing out, has created a pattern of rolling asset bubbles that characterized this era of economic history.

• The Dot Com bubble preceded the early 2000s recession.

• Housing during the financial crisis from 2007-2009.

And what now?

Post the Great Recession, low/zero interest rate policy perpetuated a sustained period of growth while governments around the world became addicted to issuing debt and running bubbling deficits to boost GDP as secular drivers of growth began to slow (e.g. globalization, demographic trends, cheap energy).

• US debt alone has grown 8500% since 1970 and sits near a staggering $34 trillion in late 2023.

Thus, the sovereign debt bubble was born.

This drunken, debt-fueled consumerism was enabled by the deflationary regime and policymakers’ exploitation of it.

Given the return of inflation, policymakers must be wary about easing their way out of economic turbulence. To do so is to risk the reacceleration of inflation. With higher rates, there is, once again, a cost to capital that will crowd out unprofitable business models and sloppy spending habits born in the era of free money.

How is the government going to service this level of debt? Inflation. To continue printing and spending money recklessly to bolster economic growth is akin to a snake swallowing its tail. This will provide a short-term boost to GDP - instant gratification at the government level - but will kick the can down the road in dealing with this debt bomb.

Rampant, runaway inflation will create a myriad of other problems. But a period of sustained inflation, running higher than the average interest rate on outstanding debt, will serve as an indirect tax, effectively eroding consumers’ purchasing power, and reducing the debt/GDP ratio to more manageable levels.

The pandemic - and policymakers’ response to it - woke the inflation dragon and caused some of the fundamental themes behind the deflationary backdrop to change. Did they kickstart an era of secular inflation? Will inflation remain elevated? Some themes to consider…

• Peak cheap energy - As ‘easily accessible’ oil reserves are depleted, extraction becomes more expensive, and prices rise.

  • The affordability of alternative energy - Independent analyst and Bloomberg contributor, Nat Bullard, explains that nearly 75% of new green energy assets were built in an environment of (sub)zero interest rates. Are these projects sustainable with higher interest rates (i.e. higher borrowing costs)?

• Deglobalization - Are world powers pushing against the dominance of the US dollar reserve system? What evidence is there that the global economy is regionalizing? How will this affect supply chains and cost structures?

The million-dollar question… is inflation actually transitory, or will it return after a cyclical contraction in demand (aka recession)?

Outlook for Recession

What is recession? Your econ teacher may define it as two consecutive quarters of contracting GDP. We experienced that in 2022, and yet, no recession. The actual definition is much more convoluted. Notable US economist, Wesley Mitchell, defines recession as a pronounced, pervasive, and persistent decline in broad measures of output, employment, income, and sales.

In essence, a recession is the contraction of demand in an economy. What we are seeing in commodities and interest rate markets in December 2023 is undoubtedly recessionary.

• Oil prices are down 23% from their October peak.

• The 10-year interest rate is over 100 basis points below its peak.

Let’s take a deeper look at yield curve dynamics…

• Rates move lower in periods leading up and into recession because markets are pricing in a slowdown in economic growth and inflation.

  → 2-year yields are anchored to Fed policy.

  → 10-year yields are more anchored to economic activity.

• As the Fed tightened monetary policy throughout 2022/2023, the front-end of the yield curve moves higher at a faster rate than the back-end of the curve as rate markets price in the lagged effects of tighter policy on economic activity down the line. This leads to yield curve inversion (higher rates at the front-end of the curve).

• Typically, the curve will steepen (or “un-invert”) at the onset of recession as the market prices in a more-accommodative Fed who will be forced to ease monetary policy (lower rates) to combat the effects of recession.

• After the Dec. Fed meeting, markets are pricing in a 37% chance of 6 rates cuts in 2024, with the federal funds rate projected to end next year at 3.75-4.00% (currently 5.25-5.50%).

Will the Fed actually ease policy so drastically with the current inflationary backdrop? If markets are correct in pricing in 6 rate cuts next year, what picture does that paint for growth and inflation? A severe, deflationary growth collapse may warrant that level of easing to bolster the economy. But if a deflationary shock occurs, it is because the Fed has already tightened policy too aggressively and we are in the grips of recession. If the ‘soft landing’ narrative proves true (i.e. a slowdown in growth without a recession or a sharp uptick in unemployment), that level of easing will likely unleash the inflation genie from its bottle once again.

→ Dec 1: US Fed Chair Says ‘Premature” to Speculate on Rate Cuts

→ Dec 13: Fed Policymakers Discussed Timeline to Start Rate Cuts

Interestingly enough, November jobs data was released between these dates and showed a DROP in the unemployment rate. And Nov. CPI increased 3.1% Y/Y. So why the sudden increase in dovish rhetoric despite hawkish data?

It would be naive to think Chairman Powell is not getting his arm twisted by politicians going into an election year or Wall Street elites who wish to bolster performance into year-end after a dismal return in 2022. It is unlikely that we will experience both a soft landing in the economy and the level of easing that is currently being priced in.

The labor market is the latest of ‘late cycle’ indicators - meaning it is the last domino to fall before main street realizes a recession has begun.

Some additional food for thought…

Jamie Dimon recently sold 1 million shares of JPM. BlackRock CEO, Larry Fink, sold $25 million of BLK, and Jeff Bezos sold 10 million shares of AMZN. Mark Zuckerberg offloaded 364,000 META shares in November, and other c-suite officials are trimming positions. Tech and banking executives dumping shares is generally not a bullish indicator. What might they see coming that the average joe is missing?

The Implications of the Credit Market

The “resiliency of the US consumer” has been highlighted throughout the year. Let’s take a deeper look at how consumers have managed to sustain themselves.

In short, household savings are nearly depleted at the same time student loan payments have resumed. Americans are relying on credit more heavily than before the pandemic, in an environment where the interest paid on that debt has risen significantly.

Specific data points may look promising (e.g. stabilizing CPI, blowout earnings, elevated GDP), but to focus on these bright spots is akin to sheltering in the local trees while the bigger picture shows the economic forest is ablaze.

Consumption is propped up by borrowing at higher rates the same way GDP is elevated due to government spending while the real economy continues to slow.

It’s a Bird… It’s a Plane… No… It’s the US Stock Market

If the underlying economy is struggling, why is the stock market pushing all-time highs? It is important to remember that there are psychological factors at play in the US stock market that are less relevant elsewhere. FOMO is rampant. Hedge funds and momentum traders are forced to chase performance. And the highest percentage of US households in history are now exposed to the market in some capacity.

The bubble mentality we discussed earlier has infiltrated the minds of novice investors who have incredible concentrations of wealth in the ‘top stocks’ that everyone owns.

The ‘get rich quick’ mentality has been preyed upon by hedge funds and money managers who are accentuating these market moves through the novel phenomenon that is same day expiry in the options markets. Known as 0 DTEs (zero days ‘til expiration), these ultra-short dated options have caused a suppression of volatility and exasperated the upside move in stocks.

Some things to consider…

Let’s take a snapshot. On 12/18 the top 10 stocks accounted for 40% of the market’s return. AMZN and NVDA alone equated to 16% of the total return. The top 10 stocks in the S&P 500 now account for 35% of the index market cap. This level of concentration was last seen at the peak of the Dot Com bubble in 2001.

It’s clear investors are buying the notion of the ‘dovish pivot’… as the Fed is setting the stage for easing policy next year. But there is reason to believe victory cannot yet be declared in the fight against inflation.

Some green shoots that help us to understand the recent rally…

The chart above is of particular importance. Liquidity is the lifeblood of financial markets. The mechanics of how overnight lending and repo operations work are complicated, but the moral of the story is that liquidity has improved since the regional banking crisis in March 2023.

The blue line indicates the draining of the reverse repo facility, which has helped to fuel an elevation in Treasury issuance. This issuance helped to fund the fiscal deficit which has been the primary driver for stronger than expected GDP growth (5.2% annualized during Q3 2023). Should this reverse repo operation continue, it will assist in keeping asset prices elevated despite ‘bubbly’ valuations.

The Fed has also admitted that the full effects of their tightening may not yet be felt. Additionally, the outlook for growth over the next 5 months is dismal. Can the government continue to subsidize growth through spending at the level they have over the last 6 months? As always, buyer beware.

Psychology of Markets

Markets often serve to upset the largest number of participants. When sentiment gets too greedy, or too fearful, it means the scales are skewed and positioning often reverses. Coming into 2023, many analysts were anticipating recession, and positioning was overly bearish.

The S&P 500 proceeded to rally 23% this year… thanks to a nearly 100% return in the “Magnificent 7” stocks.

Currently, the sentiment pendulum has swung to extreme bullishness.

One can see these levels were observed at each local peak in the stock market throughout 2022 and 2023.

The above chart is yet another indicator of extremely bullish sentiment. Nearly 47% of S&P 500 stocks are registering relative strength above the 70 level.