A Murder Mystery: What Kills the Economy?
Aug 15, 2024Why do markets crash? What causes recessions? Well, the truth is that the economy does not die of natural causes - there is usually an offender to blame. Typically, recessions and market crashes are the result of a combination of deep, underlying issues that have been developing over time, and a major, black swan event that serves as an ignition point that sets the unraveling into motion.
To some investors, the events of Friday, August 2nd, and the following Monday were signs of an impending disaster. The tightening of Japan’s monetary policy (raising interest rates to 0.25%), and a lackluster U.S. employment report (4.3% unemployment), resulted in a global market sell-off. However, it is important to note that the losses, while significant, represent a correction which brought valuations back to levels seen only three months prior, with the S&P 500 still hovering around a 10% gain on the year. Before sounding the alarms to usher in a recession, there would need to be more significant indicators or a black swan event.
There is perhaps no better example of that black swan event than the outbreak of COVID-19, which was almost entirely to blame for our most recent recession, as the world shut itself down for months. Prior to that though, there was the Great Financial Crisis (GFC) in 2007, the groundwork for which was laid by changes in government policies on housing in the 90’s, as antiquated regulations proved ineffective for a rapidly evolving banking system. The complicated collapse of the financial system and the popping of the housing bubble have been the subject of many books and films and would require far more than a sentence or two to fully explain. However, it is worth noting that despite the run-up in housing prices (the average home price in the United States more than doubled between 1998 and 2006, the sharpest increase recorded in U.S. history), the economy and market did not show drastic signs of weakness until the failure of two Bear Stearns funds and BNP Paribas limiting withdrawals from three of their funds in July and August of 2007.
The bursting of the dot-com bubble, and the ensuing recession in mid-2001 was the result of a credit crunch at a time when technology startups were trading at astronomical valuations (If you think today’s NASDAQ is expensive at 35 times earnings, try 100 times). Although pre-dating the recession by a year, on March 20, 2000, a story titled "Burning Up; Warning: Internet Companies Are Running Out of Cash -- Fast" was on the cover of Barron’s. Later that day, technology darling MicroStrategy announced revenue restatements dating back two years, and the stock fell 62%, in what James (Jim) Cramer described as the “one that popped the bubble.” The next day, the Federal Reserve (the Fed) raised interest rates, creating an inverted yield curve that ultimately led to a recession and resulted in technology company bankruptcies in the following year.
The 1990-91 recession provides another example. Here, lingering financial issues from previous recessions were compounded by the sudden shock of the Iraqi invasion of Kuwait. This event sent oil prices skyrocketing, further straining the already fragile economy. The double dip recessions of 1979 and 1980 were the result of the Fed raising interest rates to historically high levels to fight inflation that had been building up for nearly a decade, thanks to a previously accommodative Fed, the Oil Embargo of 1973, and increased government spending on the Vietnam War. What set the recession into motion though, was the Iranian Revolution in 1979, which caused the price of oil to double, and led to shortages in the U.S.
We could go on, but for the sake of time (and waning attention spans), recessions are not the result of things going too well for too long, and crashes are not the outcome of strong markets for successive years. Rather, recessions and crashes are what results when underlying issues are exposed by the occurrence of a major current event, as illustrated below.
Today, the United States economy is chugging along, but there are clearly cracks in the foundation. For starters, Wall Street’s favorite recession indicator, the yield curve has been inverted for a record long two-plus years. This is largely due to the Federal Reserve keeping short-term interest rates elevated to combat lingering post-pandemic inflation. While inflation has come down, it remains above the Fed’s target of 2%, and we believe that will remain true for the foreseeable future. The U.S. economy and stock markets have remained resilient, but their strength is tied to an increase in government spending, which is over 22% of GDP (the only times that mark has been higher was during COVID, following the GFC, and during WWII). That level of spending could prove to be unsustainable as interest rates appear to have an upward bias for the long-term, forcing the government to pay more interest to continue borrowing.
As opined in previous articles, this is likely the most challenging time geopolitically since the Cold War, and it comes at a time where the political direction of the U.S. is coming into question. Would the addition of more combatants in the Middle East and a corresponding spike in oil prices come as a major surprise? A Chinese invasion of Taiwan would almost certainly involve the United States and would throw a major wrench in the global economy, depriving countries of affordable manufactured goods and semiconductors vital to most of today’s electrical devices and appliances. Domestically, is the idea of the 2024 elections being decided in the courts out of the question? Could that lead to civil unrest? It is possible that banks and insurance companies are yet to see the complete fallout effect from a weakened commercial real estate market?
While we at MAP pride ourselves upon our stock-picking abilities, unpredictable geopolitical changes and black swan events are not something we can prevent or avoid entirely. However, in the past, we have managed to navigate through turbulent waters without drowning. Our portfolios tend to be overweight in defensive sectors like consumer staples and healthcare, two areas of the market that are currently trading with attractive valuations while offering strong dividend yields. Unfortunately, that positioning in large part is why MAP’s performance lagged in 2023, a year where investors were rewarded for making bets on expensive artificial intelligence (AI) stocks.
Although we have maintained a defensive posture in 2024, we are not burying our heads in the sand and understand the transformative potential of AI and hold a fair amount of technology names that we believe offer meaningful long-term growth potential at an attractive valuation (including some of the “Magnificent 7”). We have also added to our energy holdings in 2024 and are of the belief that the market has undervalued a sector known for strong cash flows and significant dividends, which could also appreciate should there be further developments in the Middle East. While past performance is no guarantee of future results, MAP’s portfolios have historically outperformed during market downturns, and we believe our unique, long-term approach to investing positions us well to withstand future challenges.
Managed Asset Portfolios Investment Team
Michael Dzialo, Karen Culver, Peter Swan, Zachary Fellows, John Dalton, and Nicolas Vilotti
August 15, 2024
Sources:
1https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath
3https://fred.stlouisfed.org/series/FYONGDA188S
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