Wednesday’s sharp drop in the S&P 500 Index left the U.S. equity benchmark within a hair’s breadth of a bear market. Over the last century in the United States these episodes – defined as a stock market decline of at least 20% – have been relatively brief, lasting on average less than 10 months. In recent decades, they have also become less frequent. That’s largely because the Federal Reserve has always been on hand to bail out Wall Street. But the return of inflation changes everything. With the so-called “Fed put” off the table, the next bear market could last longer and inflict more damage than those of recent memory.
If you blinked you might have missed the bear market triggered by the Covid-19 pandemic. It commenced on Feb. 19, 2020 and lasted just 33 days from peak to trough. The downturn was reversed after the Fed slashed interest rates and printed money to support the financial system. Now that American inflation is at its highest level in 40 years, however, the U.S. central bank can no longer wave its monetary wand to set everything right.
The economist Richard Duncan, author of “The Money Revolution”, points out that the Fed may even welcome a market correction as falling asset prices could help push inflation back towards the central bank’s target. With short-term rates at just 1%, there’s plenty of room for further hikes. And the Fed will only start to reduce its bloated balance sheet next month. Duncan predicts that a trillion dollars’ worth of quantitative tightening over the next year will push up bond yields, causing asset prices to fall.
When problems with subprime mortgage debt first appeared in early 2007, few commentators predicted that within a short time these toxic securities would threaten to bring down the global financial system. An unexpectedly sharp rise in interest rates could be equally devastating.
In my forthcoming book, “The Price of Time”, I cite a comment by the Boston-based hedge fund manager Seth Klarman. “The idea of persistently low rates,” he writes, “has wormed its way into everything: investor thinking, market forecasts, inflation expectations, valuation models, leverage ratios, debt ratings, affordability metrics, housing prices, and corporate behavior. Moreover, by truncating downside volatility, forestalling business failures, and postponing the day of reckoning, such policies have persuaded investors that risk has gone into hibernation or simply vanished.”
Now interest rates have started to rise and risk is out of hibernation. If ultralow interest rates were responsible for inflating an “everything bubble”, it follows that everything – well, almost everything – is at risk from rising rates. The first casualties have been the most egregiously speculative investments. Like Peter Pan’s Tinkerbell, these assets retained value only as long as people continued believing in them: think meme stocks, special-purpose acquisition companies, cryptocurrencies and the like. Securities whose valuations benefited most from falling interest rates have also been hit hard. The Nasdaq 100 Index of technology stocks is down by more than a quarter this year; some long-dated UK inflation-linked bonds have lost more than 40% of their value.
That’s not the end of it. Still-low interest rates continue to underpin the inflated valuations of U.S. stocks and real estate markets around the world. Easy money keeps zombie corporations afloat, enables governments to run outsized deficits, and boosts the profitability of financial and non-financial corporations.
Furthermore, unconventional monetary policies have lured investors into a variety of illiquid investments, notably venture capital and private equity. “Liquidity is the new leverage,” proclaims Henry Maxey, chief investment officer of London-based Ruffer. In a desperate search for yield, investors have taken their money out of banks and placed it in less-regulated bonds and exchange-traded funds. These vehicles promise daily liquidity but their underlying investments are often relatively illiquid. This is an accident waiting to happen. Already the market for new issues of leveraged loans and high-yield bonds, which are pooled into traded credit vehicles, has started to dry up.
In November 2008, China helped bring the global financial crisis to an end by launching of a massive stimulus programme. Over the following years, the People’s Republic was responsible for around half the world’s total investment spending and a similar proportion of new corporate debt. That trick cannot be repeated. China’s growth miracle has come to an end, as its economy totters under a mountain of debt and its real estate bubble starts to let out air. In recent weeks, the yuan has been falling against the U.S. dollar. China’s financial imbalances are likely to be at the forefront of the next bear market.
Despite recent market declines, U.S. stocks remain far above their historic valuation. Most investors blithely ignore this inconvenient fact. Recent history is on their side. After all, during the bear markets that accompanied the dot-com crash of 2000 and the global financial crisis that started seven years later, the stock market only briefly touched its long-run trend before taking off again. Now that inflation has returned, investors may not be so fortunate next time around.
Although shares are claims on real assets, their valuations tend to be depressed when consumer prices are rising sharply. As Warren Buffett pointed out in a famous article in May 1977, inflation puts up the cost of corporate borrowing and forces companies to increase the dollar amount of working capital simply to match the previous year’s production. “Inflation,” wrote Buffett, “acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” Investors find this organism difficult to digest.
Bear markets normally arrive and depart in short order. But the downturns of the 1970s lasted more than twice as long as recent market selloffs. More importantly, they were accompanied by a severe and prolonged decline in valuations. In 1968, U.S. stocks traded on a cyclically adjusted price-earnings (CAPE) ratio of 24 times. By the time the “Great Inflation” ended in 1982, they sold for just 7 times average earnings of the previous 10 years. Today, the CAPE ratio for U.S. stocks stands at 32 times. A return to the valuations that prevailed four decades ago would be a bear market for the history books.