We tend to get surprised by any event that’s outside the norm simply because our focus revolves entirely around the normal expectations. Hence, we are caught off guard when a pandemic occurs, or a pandemic-related sell-off transpiresor any supposedly rare event unfolds. This cycle repeats because we often fail to consider the wide array of possibilities that have a decent chance of occurring. In fact, many of these events have recurred throughout history, eliciting the same surprised response each time.
Keeping all this in mind, it strikes me that ruling out a prolonged recession or even a depression, given the current unfolding events, is a risk. On the flip side, considering all probabilities, however remote, certainly helps in being prepared for the worst. At the risk of Commitment bias, I have still felt compelled to share my thoughts.The truth remains that the future is a random variable.
Watching the events unfold lately feels like the slow-motion car fall in the movie ‘Inception.’ The car descends into the river in slow motion, the moment elongates, and the fall, though imminent, seems endlessly delayed, as if it’s not going to happen.
Before we delve into the discussion, there’s a crucial point that needs clarification. When stock valuations are relatively cheap, an investor might consider the macroeconomic pictureas irrelevant, as there are always issues ongoing. However, when valuations reach extremes, it would be imprudent to ignore the macroeconomic landscape. Lost decades tend to occur from these points, underscoring the importance of considering broader economic factors during periods of extreme valuation.
And as the world emerges from the biggest monetary experiment ever, a few things stand out.
- THE ONGOING BANKING CRISIS IN THE US(WITH BANK RUNS)
- MONEY SUPPLY CONTRACTION
- CREDIT CONTRACTION
- THE EUPHORIA
- THE EVERYTHING BUBBLE
- THE ABNORMAL LAST TWO DECADES
- EXTREME CASES OF FINANCIAL ENGINEERING
- HUGE CONSUMER DEBTAT HIGH INTEREST
- FASTEST RATE HIKE CYCLE with HIGHER FOR LONGER
- QUANTITATIVE TIGHTENING
- POLITICAL STANDOFF AND THE FED IN A TIGHT SPOT
- GENERATION THAT IN NOT EXPOSED TO INTEREST RATES
- GEOPOLITICAL CONFLICTS WITH WEAPONIZATION OF DOLLAR
- NO GLOBAL GROWTH ENGINE TO RESCUE
- THE OVERUSED FISCAL IMPULSE
- THE SIGNIFICANT INVERSION OF YIELD CURVE
- WEALTH GAP, WOKEISM AND YOLO.
- WE ALSO SEEM TO BE IN A PERIOD WHERE 100 YEAR EVENTS ARE HAPPENING ONE AFTER ANOTHER
Putting these factors into perspective, it’s hard to ignore the possibility of a prolonged recession or even a Depression. The 2008 financial crisis was a panic intertwined with a debt crisis. How did we emerge from it? By rescuing the ‘too big to fail’ institutions, merging them to make them even bigger to fail. This leads to the next question – will these even bigger to fail institutions never fail? Obviously not. Among the ten institutions categorized, it is inevitable that at some point, they will face tough challenges. What happens then? Another systemic crisis? It’s a possibility.
Since the Global Financial Crisis (GFC), a few fundamental questions arise. Has human greed disappeared after the GFC, or has the moral hazard associated with the rescue made it worse? If the answer leans towards the latter, with the moral hazard exacerbating human greed, then it’s likely that the decade-long era of free money at 0% interest rates has resulted in even worse lending standards, financial engineering (e.g., Shiba Inu, Doge coin, NFT), and more. History makes one thing clear – bubbles and periods of excess are followed by difficult economic times.
Investors may fall for the soft-landing camp, perhaps due to the stock market retracing its losses significantly, overlooking warning signs right in front of their eyes. In fact, the perceived resilience, though a façade, setting the stage for ‘Higher for Longer,’ actually makes the case for a severe recession stronger. Even the biggest one-day crash of 1987 did not result in a severe recession. One might hope for a sudden credit event prompting the Fed to intervene and postpone the side effects yet again. However, what seems to be happening, at least until now, is a slow deterioration of fundamentals with higher interest rates and quantitative tightening (QT) in the background.This in fact, sets the base for a scenario developing into a Depression.
Well, before we get into it, what is a Depression?By Definition, it is described as – A severe and prolonged downturn in economic activity characterized by a significant decline in production, widespread unemployment, reduced consumer spending and investment, and an overall contraction of the economy. Depressions are more severe and extended than recessions, which are temporary economic declines. In a depression, economic indicators such as GDP (Gross Domestic Product), employment levels, and industrial production experience deep and sustained contractions.
Key features of an economic depression include:
- Duration: Depressions last for an extended period, often several years, as opposed to the shorter duration of recessions.
- Unemployment: High and persistent unemployment rates are a hallmark of a depression, with many individuals and businesses facing financial hardship.
- Business Failures: A significant number of businesses may close or go bankrupt during a depression due to reduced consumer spending and financial stress.
- Asset Deflation: Prices of assets such as real estate and stocks typically decline sharply during a depression.
- Credit Contractions: Access to credit becomes limited as financial institutions become more risk-averse, contributing to a decline in investment and spending.
- Global Impact: Economic depressions often have a widespread impact, affecting multiple countries and regions.
Well, prior to the Covid response, one could have safely dismissed the whole notion of a depression, knowing well that the Fed could come out with a Bazooka and save the economy. But how much has the situation changed? The same Fed did come out with the Bazooka, adding 9 trillion to its balance sheet. All this on top of a decade of low-interest rates and QE, and followed it with the fastest rate hike cycle and QT.
Milton Friedman, the Nobel Laureate, repeatedly insisted on minimal fluctuations in interest rates and money supply. But what has happened in the last two decades? The exact opposite. It is a well-known fact that all interventions have side effects. However, the reactionary Fed has tried to fight too many battles, with each action laying the foundation for the next. Of course, the Covid shock and its response must be considered. But as the saying goes, ‘Stop digging when you find yourself in a hole.’ The Fed, however, has continued digging, starting with zero-interest rates, followed by QE1, QE2, and the Covid trillions simply because the inflation genie had not arrived. This gave the excuse to forget economic discipline and the principles that should be upheld. Following the raging inflation that destroyed their reputation, they have gone to the other extreme with hiking interest rates at the fastest pase.
Again, one may argue that 5% interest rates are normal, nothing significant. The problem lies in the debt level and the assurance of an extended period of low-interest rates that were promised a few months before the interest rate hikes started. However, having the dual mandate of price stability and maximum employment may be argued as the root cause for these actions of the Fed. A reminder that the Federal Reserve was set up in 1913 to provide a stable monetary and financial system. It was in 1977 that the dual mandate, which included promoting maximum employment, was enforced.
The reason we must give this a lot of attention is that this mandate is in total contradiction to the idea of capitalism and a free-market enterprise system. The concept of the invisible hand has been replaced by the Fed’s hand. Employment is traditionally created by the free enterprise, with the business cycle comprising the upcycle and recessions. Employment ranges between maximum and contraction accordingly. However, in the longer term, every cycle results in increased productivity while removing unproductive elements from the system. This whole Fed intervention has likely damaged the fabric.
Of course, not everything has been bad. The last two decades have been extremely good for the United States economy even though productivity has been relatively low. But it may have been borrowed from the future. It has led to great Innovation like AI. But everything has a cost.
The biggest fear at this point, regarding a depression, comes from the forest fire effect, as explained by Mark Spitznagel in an interview. Forest fires, akin to recessions, play a crucial role. They remove the dry timber that can easily catch fire. If we intervene and keep stopping the forest fires by artificial means, it will eventually result in the biggest wildfire, spreading throughout the entire forest, as none of it has been cleared. This analogy clearly resonates with the excesses in the economy.
As a reminder, approximately 40% of Russell 2000 companies are loss-making, and the percentage of zombie companies is at an all-time high. This is likely to bring back the bankruptcy cycle in a significant way. The extremely low bankruptcies over the last two decades may well be replaced by an extremely high level of bankruptcies, and it’s a form of mean reversion. This may play a key role, alongside the Everything Bubble, in initiating the vicious cycle of bankruptcies – bank losses – credit contraction – unemployment due to the bankruptcies – reduced consumer spending – further increasing the bankruptcies – consumer debt delinquencies – further bank losses – leading to bank runs at some point.
Adding to this, the Treasury collapse has already impacted the banks, the commercial real estate is just getting started, and the housing market may join at some point, along with the stock market. Well, that sure looks like one too many issues happening simultaneously. The Fed tried to stop the deleveraging process in 2008, and has made it far worse. At some point, Bubbles burst and deleveraging happens. And history is clear, that the bigger the bubble, worse the effects.
Some characteristic features of 1929 would be the –Technological advancement in Media, Automobile Industry, Mass productionand consumer culture. Amongst these, the Pay later credit system and the stock market commentary from the shoe maker stand out. While these are all reminiscent of the current times in each and every aspect, the Fundamental Issues related to the Banks, the Fragile Financial system and the Fed which has constrained itself, increases the probabilities significantly.
Whilst all the issues mentioned above have their significance, I will admit no one can predit how things may pan out or at what time frame. I will share my concerns over the major issues, posing the intriguing questions that strike me about them.
THE ONGOING BANKING CRISIS IN THE US (WITH BANK RUNS)
While the narrative suggests that the regional banking crisis is over, the reality differs. Pressured by the rise in Treasury yields, the situation has worsened, with long-term yields also increasing significantly. The commercial real estate crisis may well be a prolonged one, stretching over a few years, given the 2 standard deviation rise in prices. Therefore, the situation is expected to worsen, even though the narrative suggests otherwise. TheBTFP and larger banks depositing, while giving an illusion of safety, require the banks to pay higher interest, creating conditions for more high-risk lending. Despite raising deposit rates for clients to retain them, deposit outflows continue.
The most critical factor in banking, as always, remains that all banks try to sell their bad loans and raise equity at the same time, during periods of turmoil. This creates a ripple effect. Will this time be different? The frightening part remains that it takes a single day to bring down a bank in the case of a bank run.
MONEY SUPPLY CONTRACTION
There have been very few instances of money supply contraction throughout history. While it again parallels with 1929, it is true that it expanded the most ever after the pandemic. However, it is prudent to ponder whether playing down the effects of prolonged money supply contraction is wise, as Murphy’s Law states, “Everything that can go wrong will go wrong”.
CREDIT CONTRACTION
Given all the stresses in the bank, along with Quantitative Tightening (QT), we have already entered the phase of credit contraction. Historically, this phase starts after the onset of a recession, clearly indicating the gravity of the situation at hand. As delinquencies increase, issues in commercial and housing real estate, along with consumer delinquencies, start playing out. One can expect credit contraction and lending standards to worsen. In the U.S., being a credit-based economy, the significance of credit contraction is enormous.
This leads us to ponder the next question: How can the situation change? The obvious answer being QE and zero interest rates. The Fed has little choice – either push the ball further away or face the reckoning now. That decision depends on systemic risk. If systemic risk doesn’t arise, it’s hard to imagine the Fed rushing to those decisions.
THE EUPHORIA and THE EVERYTHING BUBBLE
2021 marked the pinnacle of euphoria in various sectors. Since then, the most frenzied segments of the markets have cooled down, some in a dramatic fashion. This resurgence of calm prompts us to question whether the worst is truly behind us. However, the next downward phase, potentially coinciding with deteriorating fundamentals, could unfold dramatically. The lag this time around has been lengthier compared to previous cycles, fostering the belief among investors that the worst is over.
It is challenging to foresee economic downturns when we find ourselves at the peak of a bubble, surrounded by an atmosphere of apparent prosperity. This lack of foresight has historically caught people off guard, as witnessed in the market crashes of 2000 and 1929. Nevertheless, prudence dictates considering that all bubbles are born out of leverage. The larger the bubble, the higher the leverage. Pinpointing the exact locations where leverage is concealed proves to be a formidable task. As Warren Buffett aptly notes, it is only when the tide turns that we discover who has been swimming naked.
Considering the expansiveness of this bubble, encompassing bonds (which have already experienced a burst, down around 45% from the peak), real estate, stocks, and including venture capital, private equity, and financially engineered products like cryptocurrencies and NFTs, this bubble draws parallels with the 1989 Japanese Bubble. The saving grace is that valuations are not as extreme, though the comparison is not entirely identical, given the size discrepancy between the U.S. and Japan.
In contrast to the 2000 Tech Bubble, which did not involve overvalued bonds or real estate, this current scenario involves a broader spectrum of assets. Despite less extreme valuations, the sheer size of the U.S. compared to Japan adds a layer of complexity to the comparison. The 2000 Tech Bubble resulted in a mild recession and significant wealth erosion.
As the deleveraging of these assets unfolds, the potential for extreme effects arises, particularly considering how the wealth effect has contributed positively to the economy. This situation prompts a critical question: Is it possible to prevent the bubble from bursting? The ramifications of a burst seem undesirable, and there may be merit in exploring options to prevent or mitigate such a scenario.
FASTEST RATE HIKE CYCLE and QUANTITATIVE TIGHTENING
Just as we ponder that, central banks, operating within the framework of their dual mandate (price stability and employment), have embarked on the fastest rate hike cycle in recent memory. Bubbles typically burst under the influence of central bank actions, and it appears that we may have crossed the tipping point. While the last GDP reading of 5% may suggest a different narrative, examining the Gross Domestic Income (GDI) for the last two quarters reveals a near 0% figure. This stark disparity has historically preceded recessions. The unemployment rate has edged closer to 4% (currently at 3.8%), surpassing pre-pandemic levels. Additionally, the reduction in the participation rate, exemplified by the phenomenon termed “The Great Resignation,” adds to the complexity.
These are not mere blips but rather substantial warning signals, foretelling potential challenges. In context, the banking crisis has initiated credit contraction, the collapse of WeWork has triggered real estate repricing, and the Yellow bankruptcy is indicative of broader economic stress – all of which can be regarded as precursors to a recession. The alarming aspect is that these events are unfolding well ahead of typical recessionary timelines. The actual impact of the rate hikes is expected to magnify over time.
While rate cuts and quantitative easing (QE) aid in bolstering credit in the system, the rapid increase in interest rates has the potential to bring economic activity to a standstill. Restarting the system requires time, and by the time recovery efforts are underway, the damage may already be significant.
POLITICAL STANDOFF
The political standoff in the U.S. has reached a new high, marked by the ousting of Kevin McCarthy, the Republican Speaker. This development underscores the significant divide between the political parties. Given the upcoming election and the increasing interest payments on government debt, it’s safe to say that passing any bills in 2024 will be extremely challenging. This, at the current juncture, adds to the issue, as 2008 serves as a prime example of how a very brief period gains immense importance during financial turmoil.
THE ABNORMAL LAST TWO DECADES with GENERATION THAT IS NOT EXPOSED TO INTEREST RATES and with HUGE CONSUMER DEBT
While there is widespread agreement that the last two decades of zero interest rates have ushered in extreme economic conditions, leading to a significant widening of the inequality gap, a more perilous situation looms for individuals in their 20s, 30s, and even 40s. This demographic has not truly experienced societies operating under real interest rates. Although adaptation is inevitable, the transition is bound to be challenging, given the extraordinary circumstances we are emerging from.
Credit has flowed effortlessly across the globe, and consumer debt has become ubiquitous, with credit cards and loans for home, car, appliances, and more becoming the norm. As these loans are repriced with higher interest rates, consumers are likely to feel the pinch, struggling to adjust their lifestyles. Compounding the issue is the fact that inflation has outpaced wage growth, creating a recipe for disaster. If the unemployment cycle returns, the impact is expected to be more severe. Notably, companies have secured long-duration loans at lower rates, providing them with some insulation. However, consumers find themselves in a precarious situation with limited options.
The rising delinquencies, crucial to note, take several years for individuals to recover from, exerting a ripple effect on the economy that neither lower interest rates nor quantitative easing can easily remedy.
The generational mindset of investing in negative and non-cash-flow-yielding assets is poised for a shock as interest rates rise.
QUANTITATIVE TIGHTENINGand its effects on BANKS
While the Fed’s balance sheet has expanded by more than 9 trillion and the large banks have huge reserves, the first impression always seems as though the situation is much safer. However, the devil seems to be in the details.
As quantitative easing (QE) was implemented, reserves got built. As reserves got built on the asset side, the banks lent in the same proportion, resulting in a proportional increase in liabilities. Because of this, quantitative tightening, even in small proportion compared to the huge Fed balance sheet expansion, results in an asset-liability mismatch in a fundamental way.
The ray of hope here is that the Fed will come to the rescue in an instant, as was seen in 2018. But the deleveraging of multiple bubbles, with home prices coming down significantly, may yet again pose troubled asset issues. From that aspect, it would again be imprudent to neglect the issue. Also, as stated earlier, the Fed has been acting like the Fed of the 1930s post the 2021 transient inflation issue.
If the economy goes into deflation, which remains an equal possibility (when bubbles break) compared with the next round of the inflationary wave, the Fed’s tools to handle both have shown to be ineffective. Rather, sticking to minimal intervention may help prevent extreme events.
NO GLOBAL GROWTH ENGINE TO RESCUE and RISING GEOPOLITICAL CONFLICTS
This time around, there seems to be no Global Growth Engine to rescue, unlike 2008 when China was able to do that. Instead, the whole world seems to go into deflation in a synchronized manner. Europe, Japan and China in fact, seem to add to the risks. Situation in a way, seems worse because any country can ignite the dry timber this time around.
THE POSITIVE SCENARIO –
After pointing out all the things that can go wrong, it is only right that I also showcase a scenario where things play out much better.
One way that may happen, as I already mentioned, is if something significant breaks early, and the Fed comes to the rescue immediately with lower interest rates and QE again, thereby kicking the can further down.
Another scenario that can be imagined could be interest rates lowered due to low inflation before the 2024 &2025 corporate and commercial real estate debt comes due for rollover. And the economy only goes through a mild contraction.
The other Goldilocks scenario (according to the consensus) could play out – inflation is low, interest rates are cut, the US economy is strong, and Bidenomics work. Also, all risks mentioned above are imaginary. It’s the new normal. This time is different.
Well, although it’s difficult for me to imagine these hopeful scenarios being played out, the truth remains that the future is a random variable. The conditions dictate probabilities. But the economy being as dynamic as it is, any exogenous event may change the course of events at any point in time, especially with the geopolitical conflicts (wars) that are happening.
To Conclude – We also seem to be in a period where 100-year events are happening one after another.
I strongly believe that life always has a cause-and-effect relationship. It doesn’t play out the way we expect or at the time we expect it to, but it sure does in its own way. And that’s where principles come into play, both in life and economics, to guide us on the right path.
And so, once again, in light of these risks, I strongly advise all investors to adopt a conservative and patient approach. Bad times often present the best opportunities, and opportunity favors the prepared mind.
Good times are succeeded by bad times, and bad times are succeeded by good times. This principle applies to both markets and life. Dealing with both with equanimity is crucial— as Charlie Munger has taught us.
– Dr. Siddarth.K.J
Fund Manager
Kyng Capital Management Pvt Ltd