ACTV - Musk Sees Parallels With The 1929 Crash And The Great Depression

2023-04-21 14:36:04 ET

Summary

• The Fed is currently hiking into a recession, like in 1929.
• But the Fed also hiked during other recessions, like in 1974.
• History shows that the Fed hikes if necessary, despite the economic and financial damage.
• Given the current situation, the outlook for S&P 500 is very bearish.

The Musk concerns:

Elon Musk conducted an interview with Fox host Tucker Carlson that aired on April 19, and among other things discussed the current banking crisis, the Fed, and expressed his opinion on the economic outlook.

Musk pointed that one of the times the Fed hiked interest rates into a recession was in 1929, which was followed with the Great Depression. Here are the key excerpts:

Tucker Carlson: What's your sense of the stability of the American banking system?

Elon Musk: ...I think there is a serious danger with the global banking system. There's a strong argument that the - if you were to actually market the portfolios of the banks, the loans, and whatnot, that the entire banking industry would have negative equity.

...So we really haven't seen the commercial real estate shoe drop. That's more like an anvil, not a shoe. So the stuff we've seen so far hasn't even actually hasn't even - it's only slightly real estate portfolio degradation. But that will become a very serious thing later this year, in my view... I think if we see, which we're likely to see, a drop in house prices, because the interest rates are too high.

....And so if banks end up having loan losses in both their commercial and - well they're definitely going to have loan losses in their professional portfolio but also in their mortgage portfolio, this is a dire situation.

...There is a solution to mitigate the magnitude of the damage here, which is for the Fed to lower the rate. But they raised the rate again. Now, if I recall correctly, which I, you know, important caveat I think the last time the Fed raised rates going into a recession was 1929.

Carlson: What happened then?

Musk: Yeah, the Great Depression.

Musk obviously does not think that the current banking crisis is finished. He's concerned that the banks ( KRE ) could start seeing the losses on their commercial real estate loan portfolios (due to high vacancies and higher interest rates). He's also concerned that higher interest rates could cause the housing prices to fall, which would increase the losses on the banks' mortgage loan portfolios as well.

Musk thinks that he Fed should be decreasing the interest rates in this situation. More importantly, he seems concerned that the further increases in interest rates could lead to the major financial crisis like the Great Depression, referencing the Fed's "error" in 1929.

What happened in 1929?

The Fed did increase interest rate in 1929 right as the Great Depression started, from 5.25% to 6.50%. Here's the chart:

By most historical accounts, the Fed was concerned with the high stock market valuations and the excess speculation. The banks played the key role by participating in a very profitable virtuous cycle: 1) Extend the margin credit to buy stocks, 2) higher stock prices lead to more wealth, 3) more wealth leads to more consumption, 4) more consumption leads to more loans, 5) more loans lead to more profits, and thus, 6) extend more margin credit to buy stocks - the virtuous cycle continues. Apparently, the banks ignored the Fed's warning about the dangers of such activity, so the Fed was forced to hike into the recession.

At the end, the virtuous cycle turned into the vicious cycle of deflation, where higher interest rates busted the stock market bubble, which caused the default on consumer loans, and the bank runs, which lead to widespread bank failures, and ultimately the deflationary spiral.

The Fed hiked during the recession in other episodes

But the Fed also hiked during the recessions in 1974 and in 1980. Here's the chart of the Federal Funds rate and CPI inflation.

Generally, the Fed hikes before recession to address the inflationary pressures, and then pauses and cuts as the economic and financial damage becomes evident. This was the case of the 1970 recession, as shown in the chart above.

The 1974 case

In 1973, the Fed also started to cut before the recession started. However, during the 1974 recession, inflation started to increase, and thus, the Fed was forced to hike during the recession, despite the economic and financial damage.

The 1980 case

Similarly, the Fed was forced to aggressively hike during the 1980 recession, as inflation simply would not fall even as the recession started.

The lesson

During the 1970, the Fed was primarily concerned with inflation, and showed the willingness to hike interest rates even during the recessions to lower the inflation. Generally, during the inflationary recessions, the Fed is forced to hike well above the CPI inflation, despite the economic and financial damage.

What about the current situation?

The 1929 case was the deflationary recession case, where the key concern was the stock market bubble due to excess speculation. The 1974 and 1980 cases were the inflationary recession cases, where the major concern was high inflation.

The current situation combines both of these cases, it's an inflationary recession with the stock market bubble, which makes it potentially extremely dire.

Stock market bubble

First, the based on the Shiller PE ratio, S&P500 ( SP500 ) ( SPX ) ( SPY ) is as overvalued now as it was at the peak of the 1929 stock market bubble, with the Shiller PE ratio right below 30 in both cases.

During the 1970s the Shiller PE ratio was very low, down in the 10s, thus stocks were cheap, which limited the financial damage of the Fed's recessionary hikes. Here is Schiller PE ratio chart.

High inflation

Inflation was not a major problem in 1929. Now it is. The core CPI is still above the Federal Funds rate, above the 5% level. We're in midst of the inflationary shock caused by the labor shortage, attempted energy shocks, reshoring of supply chains, the real war which can affect the global food supply, all part of the unfolding trend of deglobalization.

So, the chart below resembles the 1974 episode. The Fed (red) is trying to catch up with inflation (blue), and inflation is falling. However, as soon as the Fed pauses or cuts, inflation is likely to turn back up (due top structural trends related to deglobalization), forcing more Fed hikes despite the likely recession.

Implications

The Fed is hiking into the recession, Musk is right. And the Fed will likely "hold for longer" despite the inevitable financial and economic damage as the recession takes hold. Why? Just like in 1974, we're in the midst of the inflationary shock, and if the Fed pauses prematurely, inflation could reaccelerate.

However, unlike the 1974, we're also in the stock market bubble, just like in 1929. Thus, the outlook for S&P 500 is extremely bearish.

The only hope for the bulls is that the Fed would prematurely pause and pivot, and thus, allow the stock market bubble to reaccelerate by allowing higher inflation. Very unlikely. But we will get the first taste of this on May 3 - the next Fed meeting.

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