April 25, 2024 | OPINION | By Zoraiz Zafar
To provide an introductory disclaimer, I am somebody who likes to believe that the I-70 West would be safe to drive in the middle of a snowstorm on a spring break weekend. So, for me to argue that the state of markets is due to a sharp downward correction, there really must be something special in the soap that produced this bubble.
While the 2001-2002 tech bubble, the 2008-2009 housing market and financial crisis and the 2020 COVID-19 meltdown all had more isolated structural reasons that precipitated the drop in consumer confidence, the impending crash has many precursory warning signs. Although market crashes are a natural component of business cycles, the magnitude of these crashes varies and is determined by how quickly economic agents are able to identify and implement the due correction.
Unfortunately for us, most economic agents, from hedge funds and retail investors to monetary policymakers, have been living in a collective state of irrational euphoria for the good part of a decade.
The erstwhile era of free money, which saw near-zero interest rates between 2009 and 2022, created a false narrative that, in the long term, interest rates could always be assumed to be low. That assumption, which formed the basis of most of Wall Street’s financial models, has been laid to waste by the persistent, long-term inflationary environment of the last three years.
Around October 2022, major U.S. markets were down significantly when investors realized that interest rates would be near 40-year highs for the short term. Meanwhile, the Federal Reserve kept promising a ‘soft landing,’ implying that inflation would subsist without the economy entering a recession.
Economic agents, being the optimists that we are (recall my initial disclaimer), led a stock market rally, pushing the Dow Jones and S&P 500 indices to all-time highs. Again, this ongoing rally was based on the assumption that interest rates were only going to remain high for a short time.
In fact, economists and researchers—who bought into the ‘soft-landing’ argument—were pricing in the Federal Reserve to begin cutting rates in the first half of 2024. After several months of hotter-than-expected inflation reports, that has not and will not happen, with the earliest possible rate cut likely towards the end of 2024.
For a debt-loving economy like ours, six extra months of a tight lending environment is almost certain to put an end to any hopes of a ‘soft-landing.’ The housing market, for example, has been ‘frozen’ for the past 12 months, with unaffordable levels of mortgage rates restricting most people from selling or buying.
The longer it stays in this ‘frozen’ state, the sharper the downward correction will be. Any increases in foreclosure rates, due to rising unemployment, could catalyze a housing market collapse not seen since the late 2000s.
Similarly, the banking sector faces significant threats, with many large regional banks sitting on billions in unrealized losses on lousy, pandemic-era, low-interest bonds. Now that interest rates are expected to stay higher for longer, the bonds will only lose more value and once the banks have to realize these losses on their balance sheets, their very survival would be at risk.
Soon enough, some quant analyst at a supposedly elite hedge fund is going to hear the music stopping and initiate a chain sell-off reaction. Then, the infamous contagion effect will take hold.
Just like with every other crash, most sectors will be losers, but some will be able to absorb and profit from the falling crumbs. Asset classes that are mostly acquired with and deeply linked to leverage, will suffer the most. The ever-volatile cryptocurrency markets are likely to be one of the first victims, with the bubbling equity and real estate markets to follow suit. Conversely, commodities such as gold, oil and other rare earth minerals are expected to rally, not an uncommon feature for safe-haven assets in a recessionary environment.
To conclude, while the euphoric bliss of consistently rallying markets is great for producing dopamine rushes and some great “Dark Brandon” memes, it is not based in fundamental economic realities. Artificial optimism has simply played the role of kicking the can down the road.
No matter what you believe, there is only one outcome when you hit I-70 West in the middle of a snowstorm, and it is not particularly pretty.
Excellent, erudite & eloquent