10/06/2022 — Not So Fast
September of 2022 was the worst month the financial markets have had since March of 2020. For those who’ve been living under several piles of rocks, with their headphones on, in a cave in East Jerkmenistan, that was when the pandemic finally made serious inroads on this side of the pond. Today the pandemic slowly fades from our daily lives, but another invisible menace threatens to wreak havoc on our financial system and stifle our markets.
Rising interest rates — a child of inflation and thus a grandchild of the pandemic — continue to terrorize bullish investors hoping for a quick rebound to the lofty heights of 4300 Land. Often pointing to the rocketing ascent of markets after the initial shock of COVID, bulls see the similarities in the market’s fickle behavior of late, but astute observers acknowledge that the pandemic and rising interest rates, beyond their negative immediate effect on the economy, actually have little in common. In time they will have opposite effects.
In the meantime, markets will remain in the doldrums. Here’s why.
Once the initial panic subsided, and before humans understood all of what the coronavirus would change for society, the market quickly got to work. Trends that had already started, accelerated. The slow moving process of digitizing our lives shot forward ten years in the span of two. Mere possibilities of trimming fat off of our economic juggernaut sent markets soaring, and because the economy doesn’t catch colds, the forced re-shuffling of our system allowed a capitalist market to do what it does best: discard inefficiencies, reward intelligent innovation, and grow (or at least prepare for future growth).
That may not jive with news coverage and societal sentiment, and there is a reason for that. The macro economy and the fortunes of society are strongly correlated, but in no way move lock-step. No amount of GDP gains or economic ebullience can ameliorate the loss of a job, the destruction of a business, or any life-altering turmoil that cripples hard-earned lives and destroys families. Unfortunately, the economy-at-large loves a good shake up regardless of the human cost, and once it can see a way forward, markets usually respond with aplomb.
Tempering this excitement should be the counterweight that suffering citizens might not have the capital to contribute to the brave new economy. If enough participants drop out of the marketplace, that will likely cramp the hoped-for growth and optimism. To avoid this potential lull (likely a recession) and to appease constituents who were being forced not to work, the government decided to send people checks. Some people who desperately needed checks got them along with some people who…well, just got checks. With the specter of a recession thus vanquished (or at least pushed into the future), the market moved towards all time highs.
Without delving too much into the perils of normalizing a zero rate, it, along with the handing out of stimulus checks, made for a very tenuous economic situation. In 2020, the belief in the Fed Put (the sentiment that the Federal Reserve Bank will step in to bolster financial markets at the slightest sign of malaise) had been wed with an equally dubious policy by the U.S. Government — free cash for everyone.
At the time, many economists and lay people rejoiced. Surely there was no other way to quell the recently forced-unemployed, and keep the US economy afloat. Whether that’s true or not is another topic for a different discussion, but what is irrefutable is that billions and trillions of dollars flew out into the hands of American citizens, and in turn, some of those dollars found their way back into the bottom lines of businesses big and small. Looking back, it’s not too difficult to see how our economic response was destined to drive markets higher — at least in the short term.
September of 2022 is a different beast entirely. Partially a result of our short-sighted actions during the pandemic, the swift downturn reminded people that interest rates can have values other than zero (of course it was not always nominally zero, but after the housing crises had subsided it remained far too low). Granted, fourteen years is not a short length of time, so those who forgot this simple fact should be forgiven, but still chided. When the zero-interest game started back in 2008, most reasonable thinkers knew that at some point the loosening of the money supply on a macro scale would result in inflation to some degree — in some form or another. Loath to address the future pitfall, successive Fed lineups passed the buck (no pun intended) down the line with the hopes that…I’m not sure what they were hoping. It doesn’t seem possible to give away money, hold interest rates down, and have nothing come of it.
Now that something has come of it, rapid and shocking inflation has pushed The Fed into rapid and shocking interest rate hikes to restore some value to money. Raising interest rates hurts businesses in that they must pay more to borrow, and it hurts consumers in that they are stingier with their pocketbooks. Now that the money within has real intrinsic value, it might not be the best decision to invest in the market with all its inherent risks.
A pandemic, terrorist attack, or any immediate fear certainly can be detrimental to financial markets, but it need not be, as our actions, combined with the market’s inherent resilience recently showed. However, rises in baseline interest rates, by virtue of their effects on investment behavior, will be detrimental to financial markets. This does not mean that markets can’t rally in the face of rising rates, only that rising rates are never a tailwind to market performance.
More problematic than the current bump in rates is the still-yawning gap between current inflation (8.5%) and the Fed Funds Rate (3% — 3.25%). That gap must be shrunk before we can terminate the rate crusade, and no one knows when that will happen, certainly not the ship of fools that is the current Federal Reserve Board. Recent actions have slowed inflation’s surge, but the fight looks to be far from over. With every point of inflation goods feel more expensive, making it harder to invest in any one of the companies that constitute our markets, no matter how promising their outlook might be. Compounding this, every rate increase strengthens the hand of wallets, banks, cds, and safer havens against the same companies in their eternal battle for the public’s hard-earned — and ever dearer — dollars. It is a difficult cycle for economic growth.
Societies and markets handle events differently. Counterintuitively, fiscal and monetary irresponsibility scares markets much more than a pandemic.
So why have markets rallied? The quick and dirty answer is that the market is allowed to behave as rationally or irrationally as it desires. But the best explanation I have seen is as follows, courtesy of The Economist:
“Stocks in Asia and Europe rallied, continuing a trend seen in the American markets, as expectations rose that central banks might ease the pace of interest rate rises in response to an economic slowdown…”
Hmm. Rallying on the news of an economic slowdown. Reminds me of the time Principal Skinner had to go to the burlesque house to get directions on how to get away from the burlesque house.
Either way, if you’re waiting for an immediate market rebound similar to what we saw after the COVID panic, don’t hold your breath.
