Why are U.S. equities up 13% in 2023?
U.S. bond markets are currently inverted by 68bps, and unambiguously prophesying that there will be a deep recession. Interest rates have risen from near zero to 5% in less than eighteen months. Corporate earnings are sliding. U.K. mortgage holders are bracing themselves for rises of several hundred percent when they need to refinance. So why are equity markets so resilient? The S&P 500 has risen by 13% since the beginning of 2023.
U.S. Fed policy is focused on financial stability
In my view the main driver, as so often, is Federal Reserve and other central banks’ policy. With their right hand they are smiting inflation mightily with well publicised interest rate rises. We are clearly approaching the peak of these, but the Federal Reserve would like us to think there might be one or two more. With their left hand and much less visibility they are being generous with their balance sheets to stave off instability in the financial system.
Their reasoning is simple: while combating inflation is important, maintaining the financial system’s stability is even more so. For investors this was the really important lesson from the Silicon Valley Bank failure, when the Federal Reserve injected as much liquidity (i.e., money and credit) into the monetary system as they had taken out in the previous 18 months of Quantitative Tightening.
Quantitative Easing is good for financial markets
In an environment of slow economic growth but plentiful liquidity, the excess tends to flow to financial markets. At a high level, that is what happened during the 2010-2020 period, and is the reason why equity markets have been remarkably resilient over 2023. There are other reasons alongside too: better performance from big tech, whose earnings have largely come in above expectations; investors reluctance after so long without a recession to believe, or perhaps even imagine, that there might be one. But the strength of equities has still been surprising when cash and government bonds yield 4 to 5% and provide stiff competition for investors’ money.
In contrast U.S. bond markets are today inverted (30-year bond vs 2-year bond) by 68bps and give an unambiguous message what they believe will happen. As I have argued previously, there may well be other factors behind this, such as demand for high quality collateral from the reverse repo markets, but the message remains clear.
The facts have changed: recession is now less likely
The commentariat has broadly been more optimistic up till now, and is now becoming less so, while I am the reverse: I have been too pessimistic and am reluctantly becoming a little more optimistic. The reason is contained above: the facts have changed. Previously I expected central banks to generate a recession to control inflation. Following the rescue of SVB, they have shown by their behaviour that financial stability matters more to them than containing inflation. If recession looms, I expect them to blink first and ease monetary policy, whether with their right hand (lowering interest rates) or their left (balance sheet expansion).
In the longer-term major problems are inevitable
It cannot end happily, because western governments are becoming increasingly indebted and the magic money tree, which is effectively where we are, cannot endure for ever. Does it mean there will not be a recession? That depends on how powerful you believe the levers which central banks can pull really are. In my view there are good reasons why they are less effective than they used to be.
The main one is because the amount of liquidity swilling around the world blunts the effectiveness of lowering interest rates. Liquidity is not fungible, as our friends at CrossBorder Capital often point out, which means that it will not necessarily flow to where it is needed. A fall in interest rates today will increasingly result in money being cheaper for those who have spare liquidity but makes no difference to those who need it. There are of course exceptions (e.g., the U.K. residential mortgage market), but in the corporate world a greater proportion of borrowing today is through private debt firms or short-term overnight repo markets.
Overly plentiful liquidity also reduces the cost of money, which in turn can lead to poorer decision-making. Effectively the price signal is blunted because with cheap money it doesn’t matter if I borrow and invest unwisely. If one lender won’t lend to me, there will be another keen to put their balance sheet to work. I would argue that this has been happening over much of the last 15 years since the Global Financial Crisis. When the chickens come home to roost, and they assuredly will, the holders of these investments will find themselves without the assets to pay back their borrowed money.
At some point in the future I therefore expect a prolonged financial crisis, which will probably be accompanied by a considerable recession. But unlike many commentators and the bond markets, and at the risk of embarrassing myself, I think it is less likely to happen in 2023 or even 2024. If I am wrong about this on the technical definition of a recession, I expect it to be relatively short-lived and shallow.