Blain’s Morning Porridge, 6th Nov 2023: Markets would love an early rate cut, but would that be best for the economy?
“Pain in inevitable. Suffering is optional.”
Markets thrive on competing perspectives, but trends after the strongest narrative. Rather than pray for early rate cuts to boost prices, maybe we should figure out what would be best for the economy?
I think I have mentioned I bet I made last year: US rates won’t start to fall till summer 2024 at the earliest. I remain convinced it’s a bet I shall win. One set of weaker than expected US jobs numbers does not spell Fed early easing! However, if it’s the beginning of a trend, then it will have heralded the top of the hiking cycle – but we won’t really know till December. It will remain murky, because whatever one set of employment data tell us, the US economy is still strong and vibrant.
Back in the 2010s I was a terrible market strategist. I understood everything – how the distortion of ultra-low interest rates created massive financial asset bubbles, warping corporate investment decisions, increased inequality, spawned all kinds of speculative craziness from Crypto, NFTs, WeWork and Cathie Wood, and was staggered by the sheer unsustainability of many growth stocks.
It was so obviously unsustainable – it had to crash. It was clear financial asset values were in a massive bubble and therefore bound to burst. Didn’t happen. I lost a fortune exiting Tesla and other stocks too early. A whole generation of investment bankers, traders and investment managers learnt their trade in a financial world driven higher and higher by ultra-cheap rates. These guys are driving markets today. They want cheap rates because they know that fuels a market rally.
What I failed to comprehend back then was a basic market law: it’s not what I know, but what the market thinks that’s matters. That’s a variation on the classic market saying: “the market can stay irrational longer than you can stay solvent.” It’s also all about understanding the herd mentality and sentiment drivers – common sense barely gets a look in. In such markets, don’t trade the facts, trade the crowd.
Today, we are in a very different market with multiple different perspectives on where rates, inflation and therefore markets are going.
There is not a clear direction. That should be a great thing – lots of different views making for a buoyant liquid market? Probably not. Markets still tend to move as a herd – well, maybe a flock. Have you ever watched a nature programmes focused on Flamingos? The way the flock moves is fascinating. Makes no sense, but some hive-mind, group-think coordinates the way the flock wheels and turns. It’s quite mesmerising. If I’m right, then markets could be in for a deal of whip-saw action as the mood does a series of 180s on recession/growth prospects.
At present the market can be described on a Venn diagram with 4 main sets:
- Optimists: Based on the recent weaker data pointing to economic cooling, many market participants believe interest rates have peaked, thus bonds and stocks will bounce higher as investors pile in to be ahead of the coming everything rally. Many have already made the call on a bond rally. Despite the fact Central Bankers are clearly saying rates will remain elevated for longer, these market participants choose to hear that as “rates are about to fall”.
- Pessimists: There are those who see interest rates remaining stubbornly high – potentially rising if inflation re-ignites. The effects of higher rates are lagging and are only now coming to the fore: declining earnings will be followed by a rise in corporate defaults as an economy weaned on low rates struggles under the weight of higher debt costs. They point to leverage, mortgages, auto-loans, credit cards, as clear signals of unsustainability. Declining consumer real incomes will further depress activity while escalating wage demands drive inflation higher. Stagflation here we come? (You could argue all these points above are good reasons to cut rates now..)
- Pragmatists: There are those who believe the future path for markets lies somewhere in the middle. Choosing winners and losers in what is likely to be a choppy market will be about careful assessment of which sectors and individual names are best set to benefit as the economy adapts, and which are likely to fall. It’s a question of waiting for the right moment and understanding the many distortions still active in the market, which include issues like how the IPO market has been distorted by PE, how liquidity could accelerate weakness, or how the ongoing weakness of banks due to unrealised bond losses in a period of long higher rates might trigger systemic problems.
- Realists: With multiple crises hanging over markets – this is a time to be ultra-cautious. There are the Geopolitical Shocks reverberating from Ukraine, The Middle East, and, maybe Taiwan/China. These could still destabilise energy prices. There are economic shocks still at play in supply chains, and how China and Europe weather their current growth issues. And there are political shocks to come with a big election calendar in 2024, culminating in the US, where the NYT says Trump is set to win big!
You could add in other groups, like the Doomsters who believe markets are about to implode, spelling the end of capitalism and everything, or the Evangelists who believe the whole global economy is about to bloom on a tidal wave of AI productivity gains. Yeah, maybe.
And of course, there are potential no-see-ums. I was recently reading about Kessler’s Syndrome: the rising risk of a satellite collision in inner space triggering a cascading number of further collisions as billions of tiny shards take out other satellites, very quickly making space missions too dangerous. (The fact the Israeli’s apparently shot down a ballistic missile fired from Yemen in inner space highlights the risk!)
The reality is markets don’t price for every possible risk – just the ones most likely… At the moment, these boil down to recession or recovery based around how long interest rates remain elevated, and how long inflation is likely to remain above “target”.
As usual, I find my own views don’t quite fit any of the buckets above. I’m reckoning Central Banks would not have a problem keeping interest rates higher for longer to achieve more than just a reduction in inflation. Maybe a better question to ask is what’s the right interest rate and what is the optimal rate of inflation for the global economy than for markets?
The original announced intention of Quantitative Easing – the harbinger of Zero Interest Rate Policy – was to free up money for corporates to invest in growing the economy. (Of course, the immediate aim was to stop banks going bust!) Yet, corporate investment in factories, productivity or job creation during the QE era was tiny. Companies found stock-buy-backs a far more attractive option to return risks on capex. By raising interest rates, and raising return on capital metrics, it forces corporates to focus on investments likely to generate long-term returns. Consequences, consequences…
Any economist knows deflation can create far worse economic consequences than inflation. There is a natural rate of inflation that is just enough, and not too much, to drive corporates to improve productivity to maintain profits, improve products to maintain markets, and stimulates workers to keep pushing for better pay. As long as profits and wages remain fractionally ahead of inflation, they remain ahead! When inflation is too low – that pressure to drive growth is negligible.
Concurrent with the long-term distortion of QE we had a massive deflationary effect on Western Economies from the decreasing cost of importing goods from China. The growth of China was fuelled as it became the cheapest-to-deliver manufacturer of everything – exporting goods and deflation to the West. The rise of rates, plus geopolitical tensions, partly explains the current economic predicament of China: an economy that’s seen the massive balances generated from exports flow into a property sector now in crisis, while the export spigot is being turned down.
Put all these together and ask if a return to lower rates and inflation is an entirely sensible goal? If we want to see a long-term sustainable economy, then some pain now from realistic and sensible interest rates around current levels – to winnow-out good from bad corporates, the end the overvaluation of financial assets and to rebalance savings and investment – may be no bad thing. Maybe price stability should be replaced with price optimality?
However, resetting inflation targets higher would only diminish the need to keep rates high. The first place any politician looking for a quick re-election boost will go to exert some pressure is the Central Bank if there is any hint rates could come down!
Five Things To Read This Morning
Out of time, and back to the business of business
Market Strategist and Author of the Morning Porridge