One of the most valuable lessons from understanding macroeconomics is that the credit system is an exponential growth system. Individuals and politicians love to talk about “paying down debt”, but this is actually impossible at the aggregate level because your assets are someone else’s liabilities. And the key manner in which the aggregated system grows is through asset AND liability expansion. You can individually pay down your debt, but the only reason you’re able to do that is because someone else takes on new debt. At the aggregate level the system actually relies on expansion of both sides of the balance sheet and in sustainable economies this results in real asset creation (ie, non-financial and financial net worth increases). This occurs either through investment funded by new issuance of financial assets or by revaluation of existing financial assets. Credit booms typically involve both asset revaluation and new issuance. But the problem with some credit booms is that they lead to excesses and sometimes excess inflation. The post financial crisis period is a great example of a classic credit boom where balance sheets not only expanded in terms of revaluation, but also expanded via new issuance. The post Covid period is a great example of a period where credit expansion (mainly government credit) led to outright high inflation.
When inflation runs too hot during a credit boom the Federal Reserve tries to temper it by making credit more expensive. As I recently noted, this is working, but it’s not working as fast or as effectively as some people expected. In fact, it’s caused some people to declare that rate hikes aren’t even working at all. But people are notoriously impatient. Especially investors. I always tell people that the stock market is about a 17 year instrument, but that doesn’t stop us all from talking about it as though it’s a 17 minute instrument (I am guilty of this too!). Monetary Policy has famous “long and variable lags”. But how long has the Fed really been tight? It feels like a lifetime to many. But in reality it has only been a few months. “A few months”, you say? Yes!
Just 12 months ago the Fed Funds Rate was at 1.58%. That’s loose policy by any historical standard. It’s almost hard to believe that they were nearly at 0% just 12 months ago. Yes, markets and expectations adjusted rapidly, but credit markets didn’t tighten much. In fact, Monetary Policy didn’t start to tighten credit until a few months ago. According to the most recent lending data total lending froze in March around the same time when the bank panic occurred. This was around the time when the Fed Funds Rate was at 4.75%. In other words, while the Fed has been raising rates for well over a year now, policy has only been restrictive in the real lending market for a few months.
This is not good for economic growth. As we mentioned before, you need balance sheets to expand for the economy to expand. Private lending is one of the most important, if not the most important channel through which these balance sheet expansions occur and Monetary Policy is now sufficiently restrictive that it’s choking credit growth.
Of course, there are many other ways balance sheets can expand. The government can continue to run huge deficits, foreign balance sheets can expand, markets can revalue, etc. For example, during Covid private credit collapsed, but the government more than offset any private sector balance sheet contraction. And while government deficits are still substantial they’re magnitudes smaller than they were during Covid.
All of this is finally starting to be seen in broader macroeconomic data like the employment data. Recent employment data has been better than expected and that’s contributed to much of the optimism we’re seeing this year, but when you look under the hood it’s clear that it’s softening materially. We’re seeing softening in hourly earnings (+4.7% from the March 2022 peak of 7%), temporary employment (-3.4% YoY) and last week’s non-farm payrolls were worse than expected. In fact, private sector payrolls were the softest they’ve been in the post-Covid period at just 149K. And that data has been downgraded every single month of this year so don’t be surprised if last month’s data ends up getting revised meaningfully lower. It’s not negative. It’s not something to panic over. But it’s clear that the economy is softening broadly.
I think we’re at a super interesting crossroads for the financial markets. The sharp market decline of 2022 was pricing in a potential 2008 type outcome, but a lot of the economic data has come in better than expected. I’ve been saying the economy would “muddle through” this year. This isn’t 2008, but it also isn’t a return to the boom period. But the financial markets appear to be shifting increasingly into the “economic boom” camp. I am skeptical of either extreme bearishness or extreme bullishness.
But one thing we know is that these types of environments with an inverted yield curve, tight credit, low unemployment and high market valuations tend to be consistent with low risk adjusted returns in both private credit AND equity markets. It doesn’t mean the market is on the verge of a crash, but it does mean that any downside surprise creates an environment ripe for a lot of volatility. If you have a long time horizon none of this really matters, but if you don’t then it’s more than prudent to acknowledge and manage the risks.
It’s been a very good year for markets so far. In some components of the market it’s been one of the best years ever. But the deteriorating macroeconomic data doesn’t support a lot of this optimism and given that the Fed is likely to remain restrictive through the remainder of this year it’s hard to see how the economic boom scenario can be rationalized. Of course, this doesn’t mean you should abandon ship. We’re big advocates of “staying the course” and staying fully invested in some manner at all times. And while Mr. Market will always have his bouts of fear and greed over short periods of time a solid grasp of the long-term macroeconomic risks can serve as a ballast for managing risk across time and this remains a macroeconomic environment that is fraught with unusual risks.