2023-08-21 17:04:05 ET
Summary
- The top-down approach of investment analysis is based on the monetary policy cycle and its impact on the economy and stock market.
- Alan S. Blinder, former Vice Chairman of the Federal Reserve, believes the Fed could engineer a soft landing, but it needs "some luck".
- The current economic situation presents challenges for a soft landing, including external events and potential triggers for a hard landing such as credit risk and geopolitical factors.
Top-down approach
The top-down approach of investment analysis, and especially the timing of the business cycle, is mostly based on the monetary policy cycle. Specifically, it's a well-established fact that, since WW2, all recessions have been preceded by the monetary policy tightening cycle. In fact, I just recently published a paper in which I analyzed the bear markets in the S&P 500, and found that these recessions also produce the recessionary bear markets.
However, there were bear markets without a recession, like in 1987, and recessions without a bear market, like in 1991. Thus, in practice, it's not always clear what the outcome of the monetary policy tightening would be on the economy and the stock market.
Specifically, the no-landing case of the 1994 monetary policy tightening cycle produced neither a recession nor a bear market.
Each monetary policy tightening cycle looks in the beginning like a no-landing or soft-landing, because the monetary policy operates with lags, which are long and variable, and it's difficult to predict if, or when, these lags would push the economy into a hard landing recession and a deep bear market.
Blinder's view
Alan S. Blinder is a Princeton professor and liberal economist who served as a member of President Clinton's Council of Economic Advisers, and then as Vice Chairman of the Board of Governors of the Federal Reserve System from 1993 to 1996. He recently published a paper titled: Landings, Soft and Hard: The Federal Reserve, 1965-2022 in the Journal of Economic Perspectives.
Blinder's view is particularly interesting because he was the Vice Chairman of the Board of Governors of the Federal Reserve System in 1994 when the Fed engineered the no landing. But also, he is a major dove, and the rumor has it that his stint at the Fed was cut short due to his disagreements with the Fed Chair Greenspan.
Specifically, Blinder's view is that the Fed has a mandate to engineer a soft landing or no landing, based on the double mandate of price stability and full employment. Thus, in his view, the Fed should never tighten too far to cause the "pain" in the labor market, and it appears that he does not agree with the 2% inflation target. He is a dove.
In his recent paper, Blinder studies each episode of the Fed's monetary tightening policy since 1965, and basically concludes that the Fed is able to engineer a soft landing - with some luck.
Specifically, Blinder proposes that the Fed was able to slow the economy in each case on monetary policy tightening (soft landing), but in some episodes the external events outside the Fed's control pushed the economy into a hard landing.
Basically, in his view, the 2020 hard landing was caused by Covid, the 2009 hard landing was caused by the Lehman Brothers bankruptcy, the 1991 hard landing was caused by the Iraqi war, the hard landings during the 1970s and 1980s were caused by the oil price shocks.
Most importantly, in his view, the Fed had luck during the 1993-1995 monetary policy tightening as it was able to engineer a no-landing/soft-landing because there were no external shocks to "push" the economy into a recession at that time.
Blinder looks at the current situation in 2023 and basically provides a pessimistic view on the economy due to the fact that there are many external events currently working against the Fed's monetary policy tightening, and he concludes:
Since March 2022, the Fed has been tightening monetary policy once again- raising interest rates to fight the worst inflation since the early 1980s. Episode 12 is not over yet, and I cannot predict how high interest rates will go, how long it will take to beat inflation, nor how hard or soft the eventual landing will be. What is clear, however, is that, between the COVID-induced supply disruptions, the oil shock, and the food shock, the luck factor has run strongly against them . To achieve another soft landing under these circumstances, the Fed will have to be skillful indeed.
Essentially, Blinder sees a difficult path ahead, with a low probability of a soft landing. This is the summary of Blinder's findings from all Fed tightening episodes since 1965:
What about the credit risk?
Blinder's view is limited as he only looks at the relationship between inflation, GDP, and interest rates.
In my research, I found that the hard landings were due to the sharp increase in credit spreads. I define these "hard-landings" as "the recessionary bear markets with credit events".
In fact, the inflationary shock of 2022 and a very aggressive Fed monetary policy tightening has not produced an observable recession yet because the credit risk remains very low (see chart below for BBB-10Y spread), and despite the external shocks related to the war in Ukraine, China slowdown, tight oil supplies… none of these events has affected the credit risk - yet. Thus, based on my research, whether we have a hard landing or soft landing depends on whether there is a forthcoming spike in the credit spreads.
The hard landing triggers to watch:
By combining Blinder's research with my research, we can point to several triggers for the hard landing:
- Unfolding credit risk situation with Commercial Real Estate ( XLRE ). The expected defaults in this sector could cause a systematic increase in the credit spreads and push the economy into a hard landing.
- The unfolding crisis in the regional banks ( KRE ). As the Fed keeps monetary policy tight for longer, the regional banks could experience more deposit outflows and higher cost of funding, in addition to solvency risk as the economy slows and the commercial real estate crisis worsens, which could cause more bank failures.
- The uncertain situation with US Treasuries ( TLT ) as the supply of Treasuries keeps increasing, while the demand keeps decreasing. This could cause a spike in longer-term interest rates and cause a systematic credit event.
- The uncertain situation with the Chinese economy (FXI ), where the unfolding economic slowdown could increase the number of bankruptcies and cause a global contagion in credit risk.
- The food/energy shocks due to the geopolitical situation similar to the 1970s, which could create the waves of inflation and force the Fed to overtighten.
Implications
At this point, the S&P500 ( SP500 ) is reacting mostly to the higher global longer-term interest rates, triggered by the recent Bank of Japan tweak. However, given the long list of "unfolding situations" the outlook for the S&P 500 is very bearish, as the hard landing unfolds.
In Blinder's view, currently the Fed and the stock market really have the luck running against them. In my view, this is all part of the global macro situation, and really has nothing to do with luck - it's about the policy, and that's observable.
For further details see:
The Fed Has 'The Luck Factor Running Against Them'