What We Must Fear Is Fear Itself

The true risk in the economy two years after COVID isn’t fundamentals — it’s sentiment.

By June 2022, it seems like investors have unanimously agreed that a recession is coming. The narrative is too simple — inflation is too high, and thus the Federal Reserve have to raise rates to slow demand down, which would push the economy into a downturn.

As vaccination rates increased, COVID became less impactful. Delta and Omicron reduced vaccination effectiveness against infections, but hospitalization rates remained low among the vaccinated. Viruses generally become more contagious and less lethal as they evolve, and Omicron confirmed that trend. Thus fears of COVID causing excess deaths and dampening demand were largely gone. It’s not only that Omicron wasn’t very lethal — it’s that it confirmed that future variations are also less likely to be lethal. COVID was beaten by globalization. Globalization may have brought the COVID crisis, but the wealth generated by globalization allowed the world to lock down while keeping people living in decent conditions. The sophisticated supply chain built up since the dawn of containerization may have been disrupted, but nonetheless kept people supplied. China arrested the spread of COVID early, and kept its factories churning. America turned on the money printer, and kept people spending. The global diffusion of ideas allowed for massive advances in science and technology, and the mRNA vaccine was created in record time, led by a company founded by immigrants. But that wasn’t the only miracle. The mRNA vaccine was difficult to distribute logistically and America initially hoarded it for its own population. This time around, China also invented its own vaccine, based on inactive viral vector technology. It was less effective, but easier to manufacture and distribute. Since its own population was largely spared from COVID, it was able to distribute vaccines abroad quickly, allowing poorer countries to build herd immunity. Though heavily maligned, few things can cure its own ills like globalization did. A mere virus was no match for America’s empire of debt and China’s empire of factories. In this battle of human versus nature, humanity joined forces, and won.

The reopening trade gained strength through 2021 as demand for leisure and travel far outstripped in 2019, resulting in pricing power for leisure activities like theme parks. General consumer spending also remained strong, along with a housing boom and ensuing home improvement spend that built on the pace seen in COVID.

Housing is a strong leading indicator for consumers, which then leads industrials. People form households when they feel more economically confident, and once they do, they have to make large purchases (house, home improvement, baby products, furniture, etc). This then spurs population growth. Buying a home also allows the middle class to take on safe, low interest, tax-deductible leverage in the form of the 30-yr fixed rate mortgage for investment in the form of home equity. Americans save inadequately. But they live in a country that’s still growing, innovating, and protected by the rule of law. Thus a piece of America will appreciate in value over the long-term. It effectively tricks the consumer into building healthy equity. Homeowners live in the real world while renters live in the nominal one. Building up home equity allows people to beat inflation in a way wage growth often cannot. Into 2022, we see that as home furnishing and general consumer sectors started to weaken, home improvement continued to grow and “comp the comp” (growing on top of strong growth seen in COVID). This is because home improvement spending is driven by home price appreciation — as people feel richer, they spend more on renovations. While general retail sells to everyone, whether he/she own an appreciating home or not, home improvement only sells to people who levered up to own an asset that appreciated 20% in one year. The consumer base is much stronger.

Inflation became the main downside risk. Initially in 2021 it was largely supply chain driven. This is endogenous demand-pull inflation that’s quite healthy. As people feel wealthier and more confident, they spend more. Economic capacity initially can’t keep up, and prices go up to reduce demand. The free market thus regulates itself. The semiconductor shortage had an outsized impact, since it is vital in many electronic components and manufacturing processes for products that don’t even require semis, and its complexity requires a sophisticated global supply chain to run smoothly. That supply chain was disrupted by COVID. Shipping and logistics costs were also abnormally high, especially as Chinese ports were still being disrupted by COVID flare ups and zero-COVID policies. These factors showed up in inflation in appliances, used car, electronics, and other consumer products. Since the semiconductor shortage is largely supply constraint driven due to COVID disruptions, people thought inflation was transitory and will stabilize as COVID receded. Lower Fed rates were initially tolerated.

But COVID disruptions persisted for much longer, and other areas of inflation became a concern. The CPI indicator has a smoothing factor for shelter — it doesn’t bake in the full home price appreciation since people don’t buy new homes every year. It assumes a rent equivalent price, or what the house would cost to rent, assuming rent growth is correlated to HPA, assuming only some people move and pay the higher prevailing rent every month. Thus the 20% inflation is smoothed out and CPI is lower, but inflation will also persist for longer.

But by late 2021 and early 2022, it seemed that stickier portions of inflation — services and shelter, began to accelerate. The lower end consumer began to feel squeezed as inflation outpaced wage growth. This is still demand-pull inflation. The demand for labor increased too quickly, and thus the price for labor increased to reduce some of that demand. The economy was still balancing itself. But then Russia invaded Ukraine. Ukraine was the breadbasket of Europe, and Russia was a major energy supplier. Disruption from both sides caused exogenous supply-push inflation, which the economy cannot balance by reducing demand.

Food and gas comprise a larger portion of the low end consumer’s consumption basket. People were beginning to live worse than they did in 2019. Equity multiples contracted as people assumed that the Fed would need to aggressively tighten and drive the economy into a recession. The Fed tightened in 50bps increments and so far ruled out 75bps as some bears insisted. But the Fed lost credibility as inflation clearly wasn’t transitory as they promised. Critics insisted that the Fed is too slow to raise rates and will have to do so more aggressively later. When unemployment data came out near record lows (a normally positive sign), people sold stocks because they thought it only mean the Fed would be more daring in raising rates. Stock market decline didn’t matter, because the Fed is generally thought to respond to earnings degradation, not multiple contraction. Earnings haven’t degraded meaningfully yet, and thus doesn’t constrain rate hikes yet. Nothing else mattered other than inflation, the one thing the Fed got wrong.

The Fed had been a bulwark of stability, and its credibility allowed the credit market to function even during COVID. The loss of credibility led investors into unchartered territories. When COVID hurt fundamentals, multiples held in as we felt the pain would be temporary since the Fed would keep liquidity flowing. But when the risk free rate is influx, there’s no way to price multiples, and fundamentals would be hurt eventually. Thus the market this time can’t find a bottom until the Fed signals what a normalized risk-free rate would be. They could do so before with just forward guidance. But without credibility, inflation first needs to be tamed. People are demanding that the Fed show its work this time.

This demand is reasonable — the Fed is a lot less technocratic than people commonly assume. Investors look at real time credit card and consumer survey data that come out every week, but the Fed rely on government collected monthly statistics that come out a month and half late. They also must choose their words carefully, which often means they can’t communicate earnestly. It was very unclear what the Fed meant by “transitory” — did they think high prices were going to disappear, or just the high rate of growth of prices? Why even promise that? Why not just say: as long as the economy is strong, we will tolerate higher inflation so long as our currency is sound, and we will raise rates only so we have room to stimulate again when conditions weaken? Let the economy boom on its own, and save some dry powder for the next battle. Sentiment turned on the Fed’s credibility.

There also seems to be a general sense of malaise in the labor force beyond what econometrics can explain. University professors teach you that when there’s high demand, prices go up, stimulating more supply. Those supplying will earn more profit, further stimulating demand. The economy grows upwards. Today, consumers are feeling squeezed, but there’s still a large labor shortage. So people aren’t working harder. More people today choose to complain and suffer, as they feel that the economy is stacked against them. The economy today is certainly more unbalance than in the early 90s, but the world has never been fair. This time around, there has also been more social activism shining light on problems. But political dysfunction prevented problems from being fixed, resulting in people losing hope and motivation. The Lie Flat movement, hikikomori phenomenon, incel rage, and Great Resignation are all manifestations of an increasingly unfair economy and the resultant demotivation. Without economic capacity growing through increasing labor force participation and productivity, demand has to fall, either through inflation or a Fed-engineered recession. Sentiment turned on workers’ willingness to grow.

Corporate America wasn’t confident in the sustainability of economic strength. They weren’t willing to raise wages and increase investments enough to grow productive capacity to meet demand, because they thought demand was going to eventually fall. It’s more painful to overproduce than under-produce. The distorting effects, both up and down, of COVID made macro trends hard to predict. We are coming off of a dramatic peak from COVID, marked by healthy consumer balance sheets, record household savings, and significant wealth accumulation. This is the tightest job market in recent memory. Some deceleration and decline from the peak is normal. Even by June 2022, when the stock market has fallen ~20% YTD, there were still minimal signs of real world pain. The recession was everywhere except in reality. Walmart and Target cut guidance, but largely because they ordered too much inventory in some stay at home beneficiary categories. The consumer sector is “guilty until proven guilty”, with bears waiting for decelerations, and any beats are just interpreted as delaying an inevitably more severe slowdown. By H2’22, management teams generally don’t dare to raise guidance as current trends would warrant because investors assume nothing is sustainable and thus management is just being exuberant. Fundamental analysis of stocks was abandoned for factor trading based on the two sentence description of what a company does. Oil good, retail bad.

The market is trading purely on macro and directionality now. Any signs of deceleration would further confirm that the economy is going into a recession. Stocks have over-corrected to the downside. If sales grew 30% from 2019 and then fall 5%, stocks would trade down below 2019 levels. This is a problem of the forward looking nature of equity prices — sometimes the future is unknown, and thus stock over-react. But just because a stock is cheap for its fundamentals now, doesn’t mean it’s a buy. Fundamentals could deteriorate just because sentiment is bad, even if reality isn’t. An economy can be wished into a recession. If people believe the slowdown is more severe, spending and investments contract, and thus a recession happens. It’s all a matter of confidence now, and thus it’s a self-fulling prophecy. Sentiment turned on the economy’s ability to even grow.

America could’ve been in a different place if it had more self-confidence. The problem today is also that even if inflation settles at 4% instead of 2%, rates have to come up to 4% too. That squeezes a lot of borrowers and the heavily indebted Federal government. But in general if economic growth is strong and consumers are healthy, both of which are true today, higher rates are tolerable. The Asian economies in the 90s sustained much higher inflation as their economies grew. But Americans today don’t believe in the growth they are seeing, and believe that inflation can only be sustainable when it’s back to levels seen pre-COVID’s near-stagnation economic environment. No one ever thinks that maybe a 2% inflation isn’t a healthy norm, because it implies that an economy won’t grow. The economy is sentiment driven. Back in the 1900s and 1950s, America was seeing a period of self-confidence, and thus wealth grew at a stepped up rate. This time around it could as well — the consumers are healthy, rate of innovation is high, the Treasury and Fed showed themselves to be willing to be a put option during economic disasters. Valuations should re-rate if the government demonstrated the will and ability to cushion the downside. But investors have trouble understanding new paradigms.