Opinion: Why the Fed might not save the stock markets this time

0

Markets may be in store for additional pain

Content of the article

One of the biggest contributors to booms and busts is the tendency for investors to experience periodic bouts of long-term memory loss. During such episodes, people consider recent market dynamics to be normal, whether or not such behavior is an aberration from a long-term historical perspective.

Advertisement 2

Content of the article

It is hard to underestimate how far 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 difficult to identify any other period in history when financial markets were as influenced by ultra-low interest rates and extensive fiscal stimulus as in the past decade.

Content of the article

With the strong wind from governments and central banks at their backs, the best strategies for investors have been: buy anything from stocks to real estate to art; buy even more during dips, which have always proven to be good buying opportunities; use maximum leverage to increase buying power and returns.

Advertisement 3

Content of the article

The Phillips curve is an economic concept developed by AW Phillips that describes the relationship between inflation and unemployment. The theory holds that there is an inverse trade-off between the two variables. All other things being equal, lower unemployment leads to higher inflation, while higher unemployment is associated with lower inflation.

Phillip’s theory proved resilient for most of the post-war period. A notable exception occurred in the early 1970s, when OPEC imposed an embargo against Western countries, leading to stagflation (both high inflation and high unemployment). The second outlier covers the period between the 2008 financial crisis and mid-2021.

The genius of inflation is dormant. It had calmly remained in its bottle in the face of monetary and fiscal terms that in the past would have caused it to burst with fire and brimstone. The combination of low unemployment and subdued inflation provided a golden backdrop for corporate earnings and asset prices. But, to steal the slogan of Jaws 2, “Just when you thought it was safe to get back in the water,” inflation returned, prompting central banks to apply the brakes. It has changed the landscape in ways that have, and will continue to have, far-reaching implications for investors’ portfolios.

Advertisement 4

Content of the article

The law of supply and demand may vary over time, but it cannot be eradicated. You can either eat your whole cake at once or piece by piece over time. You can’t do both. Free money, one-sided asset prices, the risk-at-will party that has raged since 2008 has given way to the current hangover of rising inflation, higher interest rates, falling stock prices and risk aversion.

The question is whether the current market malaise is simply a hangover or a case of alcohol poisoning. The answer could come from Japan.

Undoubtedly, there are great 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.

Advertisement 5

Content of the article

Following the collapse of the most severe stock and housing bubbles in modern history, the Bank of Japan initiated 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.

Since then, Japan has become so desperately addicted to almost unlimited free money that it is unable to function without it. In 2006, the Bank of Japan decreed a slight increase in interest rates, which had a significant impact on business confidence and investment. As a result, he was forced to reduce borrowing costs to zero. For more than 20 years, the Bank of Japan has been unable to detoxify the Japanese economy and wean it off the monetary “sauce”, continuing to apply copious doses of stimulus year after year.

Advertising 6

Content of the article

Despite the current decline in markets, recent history suggests that markets remain highly vulnerable as central banks continue to take the punch away from them.

  1. A trader works on the floor of the New York Stock Exchange.

    Five reasons why the investment industry can hurt some investors

  2. The Bank of Canada in Ottawa.

    Interest rates continue to rise, but investors should start preparing for their next drop

  3. The Federal Reserve Building in Washington, DC

    Standardized interest rates are the cure, not the problem

At the end of 2015, after leaving short-term rates at zero for about seven years, the Federal Reserve began to raise its benchmark rate, bringing it to 2.5% at the end of 2018. Although it was still low by historical standards, this level caused a slowdown in economic activity and a 19.3% drop in the S&P 500 index during the fourth quarter of this year. In response, the Fed flip-flopped and cut rates to 1.75% in less than a year before dropping them to zero in response to the COVID crash.

Advertising 7

Content of the article

This episode illustrates how dependent economies and markets around the world have become on monetary stimulus. It also suggests that leaving rates below the level of inflation for more than a decade has put markets in a more fragile state.

There is a disturbing distinction between the debacle of 2018 and the current crisis of market volatility. In the first instance, inflation was well under control, giving the Fed leeway to cut rates, avoid an economic slowdown, and spur a rally in stock prices.

With inflation currently well above target, central banks are stuck. If growth starts to falter while inflation remains high, they might be reluctant to turn on the taps and save the day. I am not saying that the “Fed put” no longer exists, but rather that it is much more out of the money than it has been historically. This suggests markets may be in store for additional pain.

Noah Solomon is Chief Investment Officer at Outcome Metric Asset Management LP.

Advertising

comments

Postmedia is committed to maintaining a lively yet civil discussion forum and encourages all readers to share their views on our articles. Comments can take up to an hour to be moderated before appearing on the site. We ask that you keep your comments relevant and respectful. We have enabled email notifications. You will now receive an email if you receive a reply to your comment, if there is an update to a comment thread you follow, or if a user follows you comments. See our Community Guidelines for more information and details on how to adjust your email settings.

Share.

Comments are closed.