By David Matias
June 28, 2022 – It was a brutal week in the markets — all of the markets. While a decline in stocks has been percolating for months, it is painful to experience a decline across all asset classes. As with all bull markets, it isn’t a debate about whether it will end, but rather when and how, and who is torched along the way. The timing is the part that always keeps speculators, and even investors, in the markets for just a tad too long. Unfortunately, it is rarely a long gradual process of watching assets drop. As witnessed these past two weeks, it is happening in just days and sometimes hours.
Our discussion in this post covers just a handful of the factors that we are facing in the current market crisis—namely inflation, Fed policy, and the collapse of Bitcoin. The current situation is extremely complex: we are seeing supply chain disruptions on top of a war on top of a pandemic. Keeping in mind that we are still experiencing the seismic changes that the 2008 financial crisis triggered in economic policy, we continue to face a world in which old patterns repeat, but in ways that we could not have anticipated.
The ultimate culprit in the current market collapse is poor synchronization between monetary and fiscal policy. The Fed kept stoking the economy, and ultimately asset prices, in what was the largest experiment in the history of money: Quantitative Easing. In building an eight trillion dollar balance sheet over just a few years, much of it on top of massive fiscal stimulus during Covid, the Fed entirely failed to control inflation. By “tapping the brakes” a little too late, they have created the same pile-up you might experience on a highway during rush hour. Everyone can zoom along just fine as long as no one disrupts the flow.
The Fed’s reaction this week was to more than just tap the brakes in response to the current spike in inflation. In plain terms, the Fed is attempting to trigger a mild recession without tipping into a major one. Keeping in mind that “normal” Fed short-term interest rates in a high inflation environment are typically in the 4-5% range, at today’s 1.5%-1.75% there is still a lot of room to go. The challenge will be accomplishing a “soft” rather than “hard” landing: does the Fed manage to just slow the economy or to actually put it into a moderate recession or worse? Unfortunately, the data is always lagging, and sometimes by many months. The impact of what the Fed does now in haste will not be known for a while, increasing the likelihood that the Fed will over- or under-shoot the necessary targets to navigate a soft landing.
In the meantime, the economy is very vulnerable, especially with the war in Ukraine. Another theater of international hostilities, or any other exogenous trigger, could severely impair the global economy at this time. Inflation, however, is not going to be the primary culprit. We are already seeing rapid price drops in everything from fertilizer to new homes—drops that have developed in just a matter of weeks. The disruptions in oil supplies from the war is not to be underestimated in how it is impacting the inflation numbers, from food inputs to transportation. It is a dual supply problem — oil as the main input is higher than it has been in over a decade, and at the same time refineries are struggling to keep up with demand yet reluctant to make the necessary investments to adjust to the changing oil supply dynamic. It is a problem years in the making. With an emphasis on moving away from carbon energy sources, refineries see little logic in investing now.
Oil prices, however, will come back to earth in due course with eventual increases in production from the Middle East and U.S. shale. More interesting will be what the U.S. does with Venezuela, a country that possesses some of the largest known reserves in the world but pumps less than 1% of the daily global production because of years of U.S. sanctions. Venezuela is a wildcard in the global oil supply question as shale producers are reluctant to invest into increased production for the same reasons as refiners. The good news is that should the U.S. continue to ease the sanctions against Venezuela it would be a major benefit to the millions of Venezuelans who suffer under a failed economy.
The biggest loser thus far are the major crypto currencies, Bitcoin being an easy example to cite. As of Friday evening, Bitcoin was down 71% from its high in November 2021, a similar decline to the NASDAQ during the dot.com collapse in the spring of 2000. Bitcoin’s steep fall, combined with a series of debacles in marginal cryptocurrencies and at least one stablecoin, has created the knock-on effect of broad seizures in the market. Celsius, a crypto custody and lending platform, froze all deposits on Monday. The impact of freezing a custodian’s assets is sometimes worse than the decline in the actual asset prices. When Lehman failed in 2008, it wasn’t the fact that a lot of folks lost money on Lehman’s stock or debt, but the fact that another trillion dollars in custodial fund assets were frozen in the bankruptcy. That knock-on effect literally brought the financial system to the edge of collapse in 2008.
The current rendition of the crypto market was destined for a reckoning. There was too much hype and promise around an asset class that was supposed to be “stable, risk free, and…well, you’re stupid not to invest” [Direct quote from Michael Saylor, CEO of Microstrategies, to a room full of investors, February 2021, Miami, Florida]. In the end, Bitcoin is none of those, and neither were the many speculative tokens that were engineered to capitalize on the hype. Unfortunately, it is the last people into Bitcoin who are hurt the most, those who finally “caved” to the fear of missing out at the very end.
In the long run, however, blockchain technologies will survive and thrive. At their core, they have the potential to introduce major innovation to the economy and the world of currencies. A corollary example is Pets.com from 1999. For those who remember, it was hyped as the next multi-billion-dollar company with the advent of online pet food purchasing. Pets.com didn’t survive for long — it failed almost as fast as it was born. But two decades later the online pet food and supplies industry is an $18 billion market (IBISWorld), fulfilling the promise of 1999. The only catch is that the winner didn’t exist back then — it took another round of of e-commerce startups to prove out the execution.
But getting back to the real economy, inflation is a tricky beast, one that is more based on perception than reality. Anticipating that prices will rise, businesses tend to increase prices, even if the economics don’t warrant it. We are still at the point where inflation can be tamed rather quickly, but doing so and keeping a strong stock market are currently competing forces. In many ways the Fed’s words are far more important than their actions. By creating the impression that inflation will be in control, they might just be able to convince people that it will be.
Look for our more comprehensive quarterly update in early July. Until then, I hope that you make the most of this summer weather!
– DBM