A “triple tightening” of financial policy is roiling the financial economy. Whether or not these ructions transmit to the real economy will determine if we are near the end of this downturn, or merely at the end of the first leg down.
Financial policy interventions have loomed large over the past decade. The ultimate intended target of financial policy interventions is the “real economy”, that is, individuals and households who live on “Main St.”. Policy aims to boost their employment, their cashflows and their “animal spirits.”
The yin of financial policy – fiscal policy, impacts the economy via boosting or curtailing government spending. Fiscal stimulus has a direct route to “Main Street.”. The yang of financial policy – monetary policy, has more variable paths to households. In order to make it all the way to Main Street, monetary policy often has to take a detour through Wall Street, via the institutions and assets of the financial economy.
Conventional monetary policy – the raising and lowering of interest rates, tightens or loosens financial conditions via banks’ willingness to lend. Unconventional monetary policy such as quantitative easing was expressly designed to reduce the returns on longer dated “safe” assets, forcing investors into “breaking bad”. Even the most risk-averse of investors have been pushed to buy riskier and riskier assets.
Government responses to Covid saw one of the greatest deployment of financial policy interventions in the history of the world. With hindsight, it’s now obvious that much of the monetary liquidity intended for Main Street actually got stuck on Wall Street. And, in a curious twist, much of the unconventional fiscal policy that went direct to Main Street was promptly recycled back to the financial economy in the form of crypto and meme stocks. The financial economy saw rising values in almost every major asset class. Wall Street was the big pandemic winner.
Now, the wheel is turning. The big tap in the sky is being turned off, in a triple tightening of conventional monetary, unconventional monetary and unconventional fiscal measures. This, combined with a strong lift in inflation has set the bond barn on fire. Other asset classes have not been immune, with equities and crypto values all taking a serious hit.
So far, the pain is mostly being felt on Wall Street and in the financial economy. If it’s only institutions and asset values that are taken ill, we might have seen the worst of the infection and valuations might stabilise. But will it be that simple?
What turns a correction into a full-blown bear market is the real economy rolling over. This lowers company earnings, justifying a further double-whammy down of eps and PE. In the dot com crash, the vector from deflating valuations on Wall Street to pain on Main Street was unemployment, with over 2.2million jobs lost in 2001-02. In the GFC, the infection carrier was the housing market. The funding squeeze precipitated by the collapse of Lehman Brothers tightened bank lending, prompting mortgage defaults and house price falls. Housing is the largest asset of households in the real economy, so this triggered a significant negative wealth effect as mortgages no longer had headroom which could be drawn down.
Which brings us to today. Will the outbreak on Wall Street become an epidemic for Main Street? So far there’s been pain in meme stocks, and pain in crypto. Between late 2020 and early 2022 retail investors had put over US$1 trillion into global stock markets, with their margin loan balances and average entry prices steadily rising along with markets. US stock markets have now fallen through the aggregate average entry price, suggesting losses may start to build. Similarly, the collapse of the Terra / Luna crypto complex has wiped-out over US$55b of capital; Lehman Brothers at its peak in 2007 was “only” US$46b of market capitalisation.
These losses are significant and could lead US households to spread the pain. In order to manage their own losses, they may cut back on spending, leading to job cuts and economic weakness. Think of this as the economic equivalent of a sneeze. Or perhaps ownership of crypto and stocks is not as widespread as home ownership, and the infection remains relatively contained: economic self-isolation.
The other significant risk factor is inflationary pressures. So far, households are still buoyed by pandemic stimulus and low unemployment, but these buffers will be eroded if cost-of-living pressures persist.
Fortunately, we have all become experts in monitoring infection rates. Watching for signs of contagion from Wall Street to Main Street should be second nature to us by now. Let’s hope we don’t end up with the current “lockdown measures” in the financial economy extending into the real economy.
Originally published by Kate Howitt, Portfolio Manager, Fidelity Australian Opportunities Fund