Until the stress in the banking sector this spring, most analysts had missed how abrupt the coming downturn is likely to be. It will have three inter-related dimensions: first, an unexpectedly abrupt slump into recession; second, an unexpectedly dramatic deterioration in corporate margins and earnings (especially for the US); third, an unexpected evaporation of market liquidity and risk appetite that will coincide with, or even precede, the first two.
Why might the real economy slump abruptly? Only a year into a Fed tightening cycle, it seems strange to be anticipating such a moment. But this has been the most abrupt and material tightening cycle in four decades. The Fed’s overall policy stance has led to an effective tightening of over 600 basis points since mid-2021, easily powerful enough to drive the economy into recession by now.
But monetary policy’s impact on the real economy depends on many factors. This hiking cycle has occurred against an unusually benign backdrop. When central banks started hiking, the economic system had several buffers that should delay, possibly even diminish, the impact.
But buffers get used up. Even if growth headwinds have taken longer to build, they are now blowing strongly, as will become apparent during 2023.
Then why might the slump in corporate earnings be unexpectedly dramatic? Despite the severe hiking cycle, equity market investors have maintained a benign view of earnings prospects through 2023-2024.
This smacks of classic end-of-cycle complacency. Risk metrics are always most depressed when macro dangers are most pressing. But, in this cycle, the threat to corporate earnings is even more serious than that to the real economy. Indeed, what could well be a shallow downturn for economic activity may be very unpleasant for the listed corporate sector.
In downturns, labour costs tend to run ahead of prices, sustaining real wages for a time once the cycle has turned, thereby squeezing corporate margins. Labour has the upper hand now. In short, corporate earnings could be squeezed far harder than headline macroeconomic variables would suggest.
Finally, why might market liquidity and risk appetite evaporate unexpectedly? A decade of low interest rates has driven investors to allocate to ever riskier, more opaque asset classes. This created the illusion of lower volatility and greater market liquidity. But the return of inflation has changed everything, bringing the era of emergency monetary policy to an abrupt end.
The recent banking concerns have driven funds away from regional banks (the biggest lenders to businesses) to large banks. Crucially, they have also accelerated existing flows from bank deposit accounts towards money market funds (MMFs), which pay a much higher rate of interest. MMFs then park this money with the Fed’s reverse repurchase facility, directly reducing central bank reserves. The system has become more dependent on the Fed to back-stop market liquidity.
Over recent decades, the belief has become increasingly entrenched that the Fed’s reaction function is asymmetric: good news is good news; but bad news is never really bad news, because the expectation of looser monetary policy both limits the downside threat to earnings and reduces the discount rate applied to them.
But this has led to greater fragility, as the rise to even a historically moderate level of nominal risk-free interest rates has revealed. The danger is that inflationary momentum keeps the Fed hawkish for longer than the market can stomach.
This will be painful for investors. But it will not tip the world into a deep recession. Central bankers have the weaponry to prevent a liquidity crisis mutating into a solvency one. And they will use it. In an emergency, they will intervene.
There is a widespread view that a shallow recession will translate into a run-of-the-mill bear market which we are already some way through.
This is dangerously complacent. Given unacceptably high inflation, something has to break in financial markets to ensure that nothing breaks in the real economy.
Only financial market dislocation will create the political space for central bankers to take their foot off the brake. But they cannot hit the accelerator until this dislocation has become systemically threatening. Investors should brace for turbulence.
