Wall Street’s insistence on clinging to the past is about to screw over a lot of investors
Wall Street desperately wants the stock market to go back to the good ol’ days. You know, like during the pandemic, when interest rates were at zero, the government was mailing checks everywhere, and it seemed everyone had so much real money, they were using it to buy fake money. In that environment, any idiot — or anyone on Wall Street — could buy almost any asset, sit back, and watch its value increase. Stocks didn’t just go up, they soared.
Wall Street has even concocted a fairly convincing story for how the market will get back to this state: The Federal Reserve’s rapid interest-rate hikes will cause the financial system to seize up, they will blow holes in the real-estate sector, and layoffs — which have already hit industries like tech and media pretty hard — will spread across the economy. This will, in turn, usher in a recession that forces the Fed to reverse course and cut rates to juice the economy again. After a few months of turmoil, the market will settle back into the low-interest-rate environment that defined the pre-pandemic decade and stocks will be on cruise control once more. A return to normalcy.
There’s only one problem with Wall Street’s story: It’s completely backward.
“I think one of the great mispricings of the markets right now is the idea that we’re going to cut rates by the end of the year,” Justin Simon, the managing director of the hedge fund Jasper Capital, told me. “For that to happen we’d have to have a crisis, and I don’t see that.”
Consider instead what the world would look like if higher rates don’t break the US economy but just bend it into a different shape. In this scenario, growth persists, albeit at a slower rate. Consumers keep pulling their weight, and we don’t have a recession. There is pain in some pockets of the economy and inflation remains a concern — but there’s no immediate crisis that forces the Fed to reverse course. In this scenario, the stock market gets choppy. Some stocks will win and others will lose. Charts will look ugly. The market may go sideways. Wall Street’s stock pickers may have to sweat a bit to make their clients happy.
“There’s going to be a slowdown here and an acceleration there,” one legendary fund manager told me, “but it kind of feels like the economy is just grinding on.”
It may be less convenient for Wall Street, but the reality is that our new inflation era is by no means over — and that’s not a terrible thing. Cutting interest rates to zero was a move made to revive an economy on the brink of death. It was a pull-in-case-of-emergency valve that we pulled for so long that now it feels normal to Wall Street. It’s not. Keeping rates low in a healthy economy is like pushing an able-bodied 9-year-old kid around in a stroller. Sure, you can do it, but at a certain point you have to accept the fact that the assistance is starting to stunt their development. Or, as one family-office head put it to me, if the Fed has to resort to rate cuts to stabilize the economy that means we’ve all “become a bunch of pansies who can’t handle real estate or stock declines, and think that asset prices only go up and to the right.”
As unsettling as the bank failures and stock plunges we’ve seen over the past year can be, they are a part of capitalism, not an aberration. When circumstances shift as violently as our economic regime just did, heads will roll. And while that may make the lives of Wall Street investors a bit tougher, that doesn’t necessarily portend collapse for the rest of the economy — it’s just the start of something new.
Going backward would be a bad sign
The pandemic made the economy so weird it’s hard to tell exactly what’s coming next, but that hasn’t stopped Wall Street from trying. Every quarter, analysts warn that the recession is just around the corner — just wait six months, it’ll hit. Some even argue that the recession is here and we just haven’t seen it, like a family ghost or a sock lost in the laundry. Despite this constant caterwauling from Wall Street, Americans are working, spending, and helping the economy defy doom-and-gloom forecasts.
Earlier this month, the San Francisco Fed calculated that consumers still have $500 million in savings left over from pandemic stimulus and spending changes. In another recent Federal Reserve survey of more than 11,000 Americans, most people were downbeat on the overall economy, but when they were asked about their own personal financial situation they seemed less worried — 73% of the people surveyed told the Fed they were “doing okay or living comfortably financially,” and 63% said they could cover a $400 emergency if they needed to, near a record high for the 10-year-old survey.
Richard Hayne, CEO of Urban Outfitters
Helping to support Americans’ solid financial situation is a strong job market. The latest monthly payrolls report showed that the US added 253,000 jobs in April and the unemployment rate tied the record for the lowest since 1969. The number of people claiming unemployment insurance also remains near 40-year lows. And there are still plenty of jobs that remain unfilled. In April — when the most recent data released — job openings rose to their highest levels since January.
A strong labor market and healthy household balance sheets mean that consumers haven’t stopped spending. Given the fact that consumer spending makes up nearly two-thirds of the US economy, it’s hard to imagine some sudden economic collapse while Americans are still willing to pull out the credit card. Retail sales increased a respectable 0.4%. Auto sales, which had been sluggish during the pandemic due to supply constraints, are starting to pick up. At most, Americans have adjusted their habits, buying cheaper products or delaying big purchases. The economy is changing, and consumers are changing with it. That’s what executives at stores like Walmart and T.J. Maxx are seeing in their sales. There are even signs that some consumers haven’t changed one bit. Over at Bloomberg, Joe Weisenthal has been highlighting executives who are telling investors that if a recession is coming, no one has informed their customers.
“We currently see no signs of change in customer behavior, no indication that customers are shopping less frequently, buying pure items, or trading down,” Urban Outfitters CEO Richard Haynes said on a recent call with investors.
Back in 2009, policymakers set interest rates at zero hoping that eventually the US economy would be growing strong enough to withstand higher rates. Well, that dream has come true. The US consumer is pushing through higher rates and high inflation. It’s all happening in circumstances and at a speed no one expected — and at a time that just might not be convenient for stocks.
A choppy new world
Since the start of 2023, the stock market has been high on AI-driven hype and hopium, convinced that everything will go back to the way it used to be. The old market winners who dominated the low-interest-rate world are reversing their 2022 losses. The tech-heavy NASDAQ is up 30% and the S&P 500 has returned about 8%. When trades are made and portfolios are structured for a specific environment, Wall Street has a way of convincing itself that past performance is, in fact, an indicator of future returns. But the coast is not clear.
A resilient US economy seems like it would be a good thing for the stock market, but it also means that Wall Street consensus is treating higher rates as a temporary bout of strange weather, when they are actually a change in climate.
Inflation could stick around as strong consumer spending allows companies’ to keep prices high without losing business. A world where the Federal Reserve has to keep one eye on inflation means keeping rates higher for longer. That’s a world where savers can have a leg up on spenders and where it’s more expensive to borrow money. And the logic of investing changes: If investors can make a guaranteed 5% return investing in 10-year Treasury bonds, they’ll be less likely to put their money in a startup or venture fund that may not see returns for a decade. Highly leveraged institutions will run the risk of blowing up, so corporations will be more careful with their spending as well. Sectors with business models that rely on debt — think: commercial real estate and private equity — will experience implosions as time goes on. Torsten Slok, the chief economist at Apollo Global Management, referred to this future as a “non-recession recession.”
“The 15 years of money printing created a significant bubble in asset prices,” he said in an email to clients earlier this month. “As a result, the big correction during this recession will not be in the economy but in asset prices as the Fed continues to deflate the buy-everything bubble created due to global easy money.”
This new normal would defy Wall Street’s expectations and bring about a period that, frankly, is not as fun for stocks as the last one. The pandemic era produced back-to-back years of record corporate earnings, but now wage inflation, a more price-sensitive consumer, and higher borrowing costs are set to eat into corporate margins. It’s time for investing professionals to pick winners and losers in the market. It’s time for them to dig into a company’s balance sheets and make sure they have good management. All of this may sound basic, but in a bull market it can (and did) easily fly out the window.
“Yes, the NASDAQ is up 26%, but I don’t think we buy into rallies anymore,” Simon said. “Now we’re going into something a little more choppy or flattish.”
This should make for an interesting summer.
As with all things in investing, the key to this will be timing the transition between Wall Street’s denial of this new rate regime and its acceptance of it. The problems the economy is facing today are not the same problems it faced in the recent past. Inflation has not been defeated, and no one knows how long it will take to tame. Reshaped — but not wrecked — by these new conditions, the American economy pushes forward. There is no going back.
Linette Lopez is a senior correspondent at Insider.
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