Stocks Have Taken A Bruising. Central Banks With No Room To Manoeuvre Means More Pain Ahead.
Central banks have backed themselves into a corner and the only way out is more pain for households, businesses and investors.
Over the last year and a half I have been watching governments and central banks reacting to inflation with a keen eye. In May of 2021 I published this piece which identified similarities between the economic environment of the Dot-Com bust and our present situation. The bottom line being that it was increasing interest rates that popped the bubble back in 2001 and I feared we might see a repeat of that scenario. That turned out to be bizarrely prescient and I believe we are mid-way through another bursting. A year later in May this year I published a follow up piece titled “After More Than A Decade Of Monetary Excess Wall Street's Hangover Is Finally Kicking In”.
The Fed has been too slow to react to inflation and is now having to hit the breaks too hard and too fast. The stock market has been hooked like a drug addict on zero interest rate policy (ZIRP) since the Great Financial Crisis and that low rates environment is now ending. We are about to find out what happens to the body when the drugs are suddenly taken away.
With interest rates barely off the runway we’re already seeing markets price in the impending damage and this is compounding week by week. In 2022 so far the S&P500 is down 13% and the tech heavy Nasdaq is down over 21%, officially entering a bear market.
Since that post the S&P has dropped another 12% and the NASDAQ has dropped another 13.8%. Below you can see the S&P 500 is now down 23% from its December 2021 peak and is flirting with new lows at the time of writing…
So what happens next? I think we go lower, potentially quite a bit lower too, possibly as low as S&P hitting the 3,000 kind of area plus or minus 10%.
I think this because even though interest rates are rising rapidly, it isn’t enough and central banks are massively behind the curve. Historically, to get inflation under control the interest rate has had to exceed the inflation number. So for example to tame inflation of 9% you would need interest rates of 10% or higher. This graph visualises this quite cleanly. You can see when inflation spikes in the 70s that interest rates had to rush to catch up ultimately reaching 20% before the economy stabilised.
In the UK we are in the same position, perhaps even worse given the disastrous mini-budget unveiled by Kwasi Kwarteng which almost everyone agrees will risk making inflation even worse. The Bank of England must have been delighted to learn of the tax cuts at a time when they are trying to remove liquidity from the system…
Sticking with Normal Island for a moment I’d like to highlight a fantastic thread on Twitter by Ed Conway from Sky News who has some wonderful graphs to illustrate why we are in so much trouble…
Its true, at face value the current interest rate rises look paltry. The problem is the interest rates can’t be digested in a vacuum. What really matters is whether or not we can afford the interest payments and that is determined by how much debt you have in the first place. Put another way, it wouldn’t be a huge problem to pay your friend 30% interest if you only borrowed £10 in the first place. £3 a year is pretty manageable. So lets have a quick look at the UK scoreboard…
Oh… Oh dear. Looks like the Conservative party haven’t been particularly conservative with the public’s money. So what happens if we normalise the interest rate graph to take into account our debt burden?
Back to you Ed…
So to recap, in the UK we have inflation tickling 10%. We have interest rates that need to get above inflation (so at least 11%). Meanwhile our interest rates are barely off the ground at 2.75% and we have just learned that because of our huge debts even getting as high as 4.75% would take us to financial crisis territory. I’ll understand if you need to take a moment to re-read that a few times. Yes, we are really that screwed.
So what about the US? Well their situation is effectively the same. Check out the US national debt…
Suffice to say the US can’t afford 10% or higher interest rates either. So how the heck are our governments and central banks going to get inflation under control without bankrupting their own countries?… Seriously please tell me. Thats a genuine question, I’m not being rhetorical. One thing we know for sure is it isn’t going to be by taxing the rich.
So far as I can tell, the current plan is to try and maintain credibility by gradually hiking rates while hoping that global supply chains ease and the war in Ukraine ends such that inflation organically comes down by itself. I’m not sure I can put faith in a strategy that boils down to hoping things improve. There’s a line spoken by Billy Bob Thornton in the movie Bad Santa that I can’t help but think about in situations like this…
Why don't you wish in one hand, and sh*t in the other. See which one fills up first.
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