The writer is a financial journalist and author of More: The 10,000-Year Growth of the World Economy.
For years, asset markets have behaved more like a team. Star Trek: with the mission of “going boldly where no man has gone before”, reaching new heights and finding new means for speculation.
But 2022 has been a reminder that, just like a sci-fi series, there can be casualties on missions. In this case, the “Red Shirts” — hapless extras sent into danger along with Captain Kirk and Mr. Spock only to be killed by the monster from that episode — were the cryptocurrencies that survived the crash, culminating in the crash of FTX.
But even more traditional assets had their problems; The S&P 500 Index is down 16 percent at the time of writing, and the MSCI Emerging Markets Index is down 23 percent.
The reasons for these failures are well known and interrelated. The first was Russia’s invasion of Ukraine, which disrupted energy markets and added a “supply shock” to existing inflationary pressures. This exacerbated the second factor: the struggle of central banks to establish the right monetary policy in the face of a combination of rising prices and a blow to consumer demand. Financial markets have spent a year debating whether central banks will do little to curb inflation or do so much to bring down the economy.
Not far from the surface of this debate was a more pressing long-term issue. Given the level of debt accumulated in advanced economies, is there a limit to the degree of monetary tightening? After the financial crisis of 2007–2009, attempts to return interest rates to levels considered “normal” at the end of the 20th century were interrupted by market fluctuations. How Scotty regularly talked about the engine Star TrekUSS Enterprise: “She can’t take it, captain.”
As a result, fears about the fragility of the financial system are the best source of hope for the bulls. That is why the markets were desperately waiting for any signs of a “reversal” from the Fed. This reversal does not have to include the Fed’s decision to cut rates; just a sign that the pace of rate hikes has slowed down. At the moment of maximum danger, the markets will be saved just as Messrs. Kirk, Spock and McCoy will be “teleported” to their ship in the face of a Klingon attack.
So there was a lot of optimism this week when the Fed Manual its last rate-setting meeting. After all, inflation fell to 7.1 percent in November, its lowest level this year. And the Fed has indeed slowed down the pace of rate hikes by posting a half-point jump instead of three-quarters of a point as it used to be. But Jay Powell, the chairman of the Fed, was not yet ready to save the markets. The central bank needed to see “significantly more evidence” that inflation was declining before easing monetary brakes. The Fed’s forecasts included higher rates, higher inflation and slower growth than its previous forecasts.
Perhaps investors’ desperate need for reassurance from the Fed should be food for thought. In a normal cycle, interest rates should rise as the economy picks up, but stock markets can still thrive as earnings forecasts are revised upward.
After the financial crisis of 2007-2009, a less healthy combination emerged. Economic growth has disappointed developed countries, but this has not deterred risky assets; stocks, high-yield debt, and real estate flourished. It’s really cool? Ultra-low short-term interest rates may have made it much easier for the corporate sector to self-finance, but may have allowed too many “zombie companies” to survive and thus prevented the “creative destruction” needed to transform the economy and boost productivity.
A world in which the economy is stagnant and financial markets are booming would strike Spock as highly illogical. But it is quite possible that in 2023 this pattern will resume. All the markets want at Christmas is hope for lower rates; a stronger economy is not really required.
For something to change, one of three things must happen. First, inflation will take hold in developed countries, as happened in the 1970s. This is not out of the question; the combination of an aging population and suppression of immigration could result in a wage-price spiral. In turn, this would eat into corporate profits and therefore stock market valuation. The second possibility could be a combination of high energy prices and tighter monetary policy, leading to a collapse in markets and the economy. Again, this could happen; this happened in the early 1980s.
The third option would be much healthier. Somehow advanced economies can achieve productivity gains that can lead to faster economic growth and a higher standard of living for all; such a combination should be good for asset markets as well. Unfortunately, in the absence of some fantastic technological breakthrough, this seems like the least likely outcome of the three. In an ideal world, both markets and the global economy could, in Spock’s phrase, “live long and prosper.” But all too often, only those who work in the financial markets prosper in the real world.