“Forget all the numbers you saw in 2021. Carry on as if those numbers were never real. They may never come back” – Brad Gerstner, Founder & CEO of Altimeter Capital ($18bn AUM)
Just two weeks ago, the US stock market was in meltdown. The S&P 500 slumped into bear market territory, down 21% from record highs in January. Stocks started picking up last week, bringing some hope that we might be on our way to recovery.
Could this be the end of the stock market dip?
Why were stock prices falling?
The market is currently facing three key issues of uncertainty: Inflation, Interest Rates, and Recession.
Inflation
Inflation is the continuous increase in the general price level of goods and services in an economy. As we learned in this article, inflation is good, but too much inflation isn’t. The US has a target inflation rate of 2%. Last week, the US printed the highest inflation rate it has ever seen in 4 decades, 8.6%.
What’s driving the current US inflation?
Brief economics lesson.
There are two leading causes of inflation, cost-push and demand-pull.
As the name implies, cost-push inflation is caused by an increase (or push) in the cost of inputs to production. Such as increases in salaries, oil prices, commodity prices, etc. While demand-pull is caused by a rise in demand due to consumers spending more money.
The demand-pull aspect of the current US inflation was caused by the COVID relief programs the US implemented. Primarily the quantitative easing and stimulus packages which injected over $5 trillion money into the US economy.
How did the stimulus cheques cause this?
The way economies currently run, the total money in circulation typically reflects the value of goods and services produced/available within a set time. For every $100 in circulation, there are goods (and services) worth $100 to account for/spend that money.
If we increase the amount of money in circulation without increasing the goods and services available, the price of goods and services has to rise to absorb the excess money.
For example, if the amount of money in circulation increased from $100 to $200 while goods and services remained the same, the price of goods has to double on average to account for that excess.
Put another way, when the amount of money in circulation increases to $200, there is more money chasing the same number of goods and services, and to balance the scale, the price of goods and services has to increase to account for the excess cash.
In the initial days of the pandemic, when people were in lockdown, and many were out of work, the US government had to stimulate the US economy with additional cash. Because, in terms of our example, while the goods and services available were still worth $100, the amount of money people were willing and able to spend was less than that.
So, the stimulus helped to balance the scales and avoid an economic recession in 2020. However, the subsequent stimulus packages that came in 2021 after lockdowns were over and things were going back to normal overstimulated demand and led to demand-pull inflation.
The US is also experiencing cost-push inflation caused by global supply chain constraints and the Russia-Ukraine war, driving up oil, wheat, and precious metals prices.
Interest rates are the most effective tool at the Fed’s disposal when fighting high inflation.
Interest rates
Raising interest rates is generally seen as one of the most effective tools to reduce inflation. Higher interest rates mean it’s more expensive for individuals and businesses to borrow money to spend. Thus causing spending and inflation to fall.
It’s worth noting that raising rates will not immediately solve the inflation problem. It could take more than three quarters before we see the full impact of interest rates on inflation.
Also, interest rates are more effective against demand-pull inflation but do little to curb cost-push inflation. In fact, higher interest rates are more likely to cause recession when inflation is caused by higher costs.
Why?
Because while higher interest rates drive down demand, prices remain high because costs are still high. And if prices remain high while demand is low, a recession is imminent.
The Fed cannot sit on its hands because inflation has both demand-pull and cost-push elements. So they must reduce demand even if it threatens a recession.
What can the Fed do about Cost-push inflation?
Not much. Global supply chain problems stem from the explosive demand at the end of COVID lockdowns. It’d take a year to get a car or a couch delivered now. The recent COVID lockdowns in China are not helping supply chain problems either.
The word “global” in front of supply chain constraints implies that the problems with the supply chain can’t be solved by just one country. Then there’s the Russia-Ukraine war.
Even if the war in Ukraine ends today, it will take several months to years before production can return to normal levels and reduce the cost of wheat. There are other political questions around whether the world will treat Russian oil the same way it did pre-war.
So, it’s a bit of a sticky situation. For now, the Fed can only raise rates, sell bonds (quantitative tightening), and hope it doesn’t trigger a recession.
Recession
A recession is when a country records two consecutive quarters of negative GDP growth. The US has already seen negative GDP growth in Q1 2022. If Q2 shows negative growth, the US will technically be in a recession.
As we learned in this article, recessions are generally not good for stocks. So if the US enters into a recession, we can expect that stocks will dip even further.
When will stocks fully recover?
Not any time soon.
Sharp falls in stock prices are often followed by moments of relief like what stocks saw last week. That moment of relief is called a “dead count bounce”. While it might be tempting to see those moments of relief as a sign of recovery, this might not be the case because there’s still plenty of market uncertainty.
Before US stocks can recover to the highs we saw in 2021; the US economy will need to get inflation under control, either avoid a recession completely or enter a recession and come out of it and get interest rates to neutral levels.
Nobody knows exactly how long this will take to happen. But we know it’s going to take a while.