Wall Street's insistence on clinging to the past will screw many investors
Wall Street desperately wants the stock market to go back to the good old days. You know how during the pandemic when interest rates were zero, the government was sending checks everywhere and it seemed like everyone had so much real money that they were buying fake money with it. In this environment, any idiot — or anyone on Wall Street — could buy almost any asset, sit back, and watch its value soar. Stocks didn't just go up, they shot up.
Wall Street has even come up with a pretty compelling story of how the market will get back to this state: The Federal Reserve's rapid rate hikes will lead to a collapse in the financial system, holes in the real estate sector, and layoffs in industries like tech and media already hit hard – will spread to the entire economy. This, in turn, will trigger a recession, forcing the Fed to reverse course and cut interest rates to restart the economy. After a turbulent few months, the market will settle back into the low interest rate environment that characterized the decade before the pandemic, and stocks will be back on cruise control. A return to normal.
There's just one problem with Wall Street history: it's completely backward.
“I think one of the biggest mispricings in markets right now is the idea that we're going to cut rates by the end of the year,” Justin Simon, managing director of hedge fund Jasper Capital, told me. “We would have to have a crisis for that, and I don't see that.”
Instead, consider what the world would be like if higher interest rates didn't destroy the US economy, just shaped it differently. In this scenario, growth will continue, albeit at a slower pace. Consumers continue to take their share and we do not have a recession. Some parts of the economy are struggling and inflation remains a concern – but there is no immediate crisis forcing the Fed to change course. In this scenario, the stock market becomes choppy. Some stocks will win, others will lose. Charts will look ugly. The market could trend sideways. Wall Street stock pickers might have to work up a sweat to keep their clients happy.
“There will be a slowdown here and an acceleration there,” one legendary fund manager told me, “but it kind of feels like the economy is just going to carry on.”
It may be less convenient for Wall Street, but the reality is that our new era of inflation is far from over – and that's not a terrible thing. Lowering interest rates to zero was a move to revitalize an economy that was on the brink of death. It was an emergency valve that we've operated for so long that it now feels normal to Wall Street. It is not. Keeping interest rates low in a healthy economy is like pushing a healthy 9-year-old around in a stroller. Of course you can, but at some point you have to accept the fact that support starts to slow down your development. Or as one family office boss 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 a housing or stock downturn, and…” I think asset prices are only going up and to the right.
As troubling as the bank failures and stock market slumps we have witnessed over the past year are, they are part of capitalism, not an aberration. When circumstances change as drastically as our economic system has just done, heads will roll. And while that might make life a little harder for Wall Street investors, it doesn't necessarily mean a collapse for the rest of the economy — it's just the beginning of something new.
A step backwards would be a bad sign
The pandemic has freaked out the economy so much that it's hard to know exactly what's 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 and it will come. Some even argue that the recession is here and we just haven't seen it, like a family spirit or a sock lost in the laundry. Despite this constant clamor from Wall Street, Americans are working, spending, and helping the economy weather the bleak forecasts.
Earlier this month, the San Francisco Fed calculated that consumers still have $500 million in savings due to pandemic stimulus measures and spending changes. In another recent Federal Reserve survey of more than 11,000 Americans, most people were negative about the overall economy, but when asked about their personal financial situation, they seemed less concerned — 73% of respondents told the Fed it was them “doing so well”. okay or financially comfortable,” and 63% said they could cover a $400 emergency if needed, near a record high for the 10-year survey.
Richard Hayne, CEO of Urban Outfitters
A strong job market helps support Americans' financial health. The latest monthly payroll report showed that the US added 253,000 jobs in April and the unemployment rate hit its lowest level since 1969. The number of people filing for unemployment insurance also remains near a 40-year low. And there are still many vacancies. In April – when the latest data was released – job vacancies rose to their highest level since January.
A strong job market and healthy household balance sheets mean consumers haven't given up spending. With consumer spending making up nearly two-thirds of the US economy, it's hard to imagine a sudden economic meltdown while Americans are still ready to pull out their credit cards. Retail sales rose a respectable 0.4%. Auto sales, which stagnated during the pandemic due to supply shortages, are starting to pick up again. At best, Americans have adjusted their habits, bought cheaper products, or postponed large purchases. The economy is changing and consumers are changing with it. That's what executives at stores like Walmart and TJ Maxx see in their sales. There are even signs that some consumers haven't changed a bit. Over at Bloomberg, Joe Weisenthal has singled out executives who tell investors that in the event of a recession, no one has informed their clients.
“We're not seeing any sign of a change in customer behavior right now, no sign that customers are shopping less, buying item-only or trading at lower prices,” Urban Outfitters CEO Richard Haynes said in a recent call with investors.
In 2009, policymakers set interest rates to zero in hopes that the US economy would eventually grow strong enough to withstand higher interest rates. Well, that dream has come true. The US consumer is pushing for higher interest rates and high inflation. It's all happening under circumstances and at a pace no one anticipated — and at a time that may not be favorable for stocks.
A troubled new world
Since the beginning of 2023, there has been an AI-driven hype and glimmer of hope on the stock market, in the belief that everything will go back to the way it used to be. The old market winners that dominated the low-interest world are recouping their losses from 2022. The tech-heavy NASDAQ is up 30% and the S&P 500 has returned about 8%. By making trades and structuring portfolios for a specific environment, Wall Street manages to convince itself that past performance is in fact an indicator of future returns. But the coast is not clear.
A resilient US economy appears to be a good thing for the stock market, but it also means that the Wall Street consensus views higher interest rates as a temporary bout of unusual weather, when in fact they represent climate change.
Inflation could linger as high consumer spending allows companies to keep prices high without losing business. A world where the Federal Reserve has to keep tabs on inflation means keeping interest rates higher for longer. This is a world where savers can have an advantage over spenders and where it's more expensive to borrow money. And the logic of investing is changing: If investors can earn a guaranteed 5% return on an investment in 10-year Treasuries, they're less likely to put their money in a startup or venture fund that might not be around for a decade return achieved. Heavily indebted institutions are at risk of going bust, which is why companies will also be more cautious about their spending. Sectors with debt-based business models – think commercial real estate and private equity – will see implosions over time. Torsten Slok, chief economist at Apollo Global Management, described this future as a “recession without a recession”.
“The 15 years of money printing has resulted in 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 by global easy money.”
This new normal would go against Wall Street's expectations and usher in a phase that, frankly, stocks aren't enjoying as much as the last one. The pandemic era produced record corporate profits for years, but now wage inflation, a more price-sensitive consumer and higher borrowing costs will squeeze corporate margins. It's time for investment professionals to pick the market's winners and losers. It's time they looked at a company's balance sheets and made sure they were well managed. All of this may sound simple, but in a bull market it can (and has) easily been thrown overboard.
“Yes, NASDAQ is up 26%, but I don't think we're going to rally any more,” Simon said. “Now let's move on to something more choppy or flat.”
That should make for an interesting summer.
As with all things investing, the key will be planning the transition between Wall Street's rejection of this new interest rate regime and its acceptance of it. The problems facing the economy today are not the same as in the recent past. Inflation is not over yet and no one knows how long it will take to contain it. Reshaped—but not ruined—by these new conditions, the American economy is moving forward. There is no turning back.
Linette Lopez is a senior correspondent at Insider.
Read the original article on Business Insider