01 Apr An Economic Intermission

“No one enjoyed watching this past year’s “The Big Bust.” Inflation, crypto winter, bank crises. Wow! How will this movie end?” – The Lonely Realist

The Big Boom, America’s favorite movie for more than a decade, ended its run more than a year ago. Its sequel, The Big Bust, has been playing since then. We are now at an intermission(?), which provides an appropriate moment to determine whether to stay and watch, walk out, or plan on a double feature.

The first half of The Big Bust, though exciting, was a downer. It began with transitory inflation climbing to an annual rate of more than 9%, shocking the audience. Economy-watchers wondered whether prices would continue to rise into double digits. Would the 2020s witness a repeat of the 1970s? In an inspirational plot twist, the Federal Reserve raised interest rates from 0.25% at the beginning of 2022 to 4.25% by its end, an unprecedented tightening. Although this brought applause from a majority of the audience, a minority quickly exited the theater to dispose of their leveraged bets, fearing the consequences of higher interest rates and tighter monetary policies. The rest of the movie public experienced those consequences as stock and bond markets dropped by 20%, bottoming in October. Although villains aplenty have continued to lurk off-screen, rising stock prices sparked a surge in confidence and a belief that the markets had survived a potentially stormy Winter. Some of that optimism evaporated in mid-March when bank crises lit up the big screen. “What might be next?” the audience asked as the curtain came down for intermission.

Members of the audience for the most part have been staying in their seats, maintaining their equity positions in the belief that The Big Bust has run its course and is being followed by The Big Boom Again. Some members, however, are thinking of leaving the theater to avoid the potentially unhappy ending suggested by the film’s title, wondering whether they should sell their equity positions and place the proceeds in US Treasuries to earn interest at ~4.5%. Yet other members are considering a visit to the lobby to buy popcorn at the investment banking counter or candy at the crypto table.

To some, the plot of The Big Bust ominously resembles events presaging the Global Financial Crisis. Serial bubble burstings similar to recent occurrences began in April 2007 when New Century (a REIT) filed for Chapter 11 bankruptcy, then in June/July 2007 when two Bear Stearns hedge funds failed, etc. …, all of which culminated in the collapse of Lehman Brothers 15 months later in September 2008. Despite the portents, markets continued rising until October 2007 …, much as today’s stock markets have been rising since October 2022. The 2022 unravelings in crypto markets were among the first of the recent bubbles to burst. The latest began with Silicon Valley Bank, leading to March’s government bailout of bank deposits. Will the resulting government guarantees and assurances put an end to market concerns? Or will unforeseen consequences, analogous to those occurring during the Global Financial Crisis, create a domino effect?

Although no foreseeably impactful economic events beckon during April, there are, as always, potential surprises. These include bank contagion spreading to commercial real estate, venture businesses, and other highly-leveraged asset classes that experienced substantial investment inflows during the past decade+ of historically low interest rates and extravagant credit policies. And, of course, early May will bring the next Federal Reserve meeting with an expected increase in the Federal Funds Rate of 0.25%. Unless the Fed alters its present guidance, the markets believe that May will mark the Fed’s final tightening in the current hiking cycle, with rates topping out at 5.25%. This means that, in the absence of [data] surprises, intermission is likely to last into the Summer.

If so, economic risk is likely to rise and fall based on how America’s debt ceiling impasse is reconciled … which today is indistinguishable from the political theatrics that accompany it. The debt ceiling is an archaic self-imposed Congressional limit on how much the U.S. can borrow. This means that the amount of deficit spending enacted by Congress and signed into law by the President must be subsequently ratified by a Congressional raising of the debt ceiling. The current $31.4 trillion ceiling was breached earlier this year and, while waiting for Congress to take action, the Treasury Department has been using accounting gimmicks to continue paying government bills. The Treasury estimates that the “extraordinary measures” it is employing can defer default only through early June, although the Congressional Budget Office believes that default can be averted until sometime between July and September. The uncertainty created by this slippery timeframe itself weighs on the markets. It goes without saying that if the debt ceiling is not increased, economic chaos will follow. Yet that remains the outlier. Neither political party wants America to default on its debts. Yet that common goal has not prevented House Republicans from playing chicken with the debt ceiling.

Lifting the debt ceiling used to be routine. Since 1960, Congress has raised the ceiling 78 times, 49 under Republican presidents and 29 under Democratic ones. House Republicans, however, are refusing to raise the debt ceiling without Democrats agreeing to a package of spending cuts that Republicans have yet to articulate. The reason is that, to date, House Speaker McCarthy has been unable to forge a Republican consensus. He reportedly is in the process of drafting a package that he hopes will be approved by the Republican majority in the House. Perhaps. With current divisions among House Republicans, that may prove a Herculean task. It is only after McCarthy has cemented that Republican majority that inter-party negotiations can commence. Time is short. And, yet, the fact that Republicans are playing debt ceiling chicken with the prospect of assured national destruction does not change the reality that the outcome is not in doubt. The national interest will prevail over the political one. Each party will exalt form over substance to claim victory. If the markets view the negotiated outcome as favoring economic growth, corporate profits and earnings will thrive, driving the markets higher. However, if the political settlement is viewed as shambolic, or if inflation begins creeping up, or if excessively indebted companies begin defaulting, or if …, then intermission will come to an unsatisfactory end.

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Finally (from a good friend)