Just a few weeks back, I penned a sunny and optimistic piece about the growth of the CRE CLO market in 2022 and by implication, the general amicable economic conditions on which the growth of that technology would depend. Being your basic risk-adverse type, I, of course, conditioned and limited my happy talk by excluding bad things that might proceed from disease, dictators and the Fed.
While I’m sticking by my predictions, my carve-outs seemed both more than a tad fainthearted and capacious enough to eat the proposition.…The Green Bay Packers will win the Super Bowl (by the way they will), assuming they get to the game and score more points than the other team. Not really helpful, is it?
What about those black swans? What about those fat tails? What about the possibility of discontinuity, can they be reasonably dismissed? Can we stop waking up at 3 a.m. in the morning (something I regularly do, regrettably) to worry about these things?
So, I took a stroll down memory lane to look at how the stock market (as an imperfect but not irrelevant proxy for the performance of the overall economy) performed when bad geopolitical, monetary or fiscal events occurred over the past many decades. It’s an easy list to compile, and at the outset all of these seem reasonable suspects for events which could have caused economic disruption. If an event caused such a disruption in 1919, would a similar event cause it again? Does that possibility portend bad things in the next year? The result of this not very empirically rigorous analysis, while far short of compelling, is directionally suggestive.
Not to bury the lede, that while monetary and fiscal missteps have been the cause of many significant economic disruptions over the last century, nonfinancial bad things haven’t resulted in much economic damage.
I looked at several, somewhat randomly selected, potential disruptors over the past century. I looked at the start of World War I in August of 1914, our entry into the War three years later, I looked at the fall of France in 1941, Pearl Harbor, the commencement of the Korean War, the commencement of the Iraq War, the Spanish Flu and the 1974 Arab Oil Embargo. All surely consequentially bad things, but did they trigger significant damage to the economy?
Here’s a brief and unscientific summary of what the record reveals. The events surrounding the commencement of World War I were a major yawn here in the United States. Barely a blip. Our entry into the war caused a significant downturn in the stock market, but within less than 18 months the damage had been repaired and the market was rocking and rolling.
A fairly similar story in World War II. The market lost about 6% when France fell in June of 1940 and then fell an additional 6% in the lea of Pearl Harbor. But 6 months after Pearl, the Dow was up roughly 7%.
How about the Korean War? The market dropped 12% in the weeks following its commencement but later that year was up almost 19%. The invasion of Iraq never even earned its wings as a black swan in the first instance and we saw the stock market increase almost immediately in the week after the war began (Oops, that would be hostilities following an authorization to use military force, not war. One must be precise.)
Moving onto the next Horseman of the Apocalypse, how about disease? Well, we know what’s been happening now with Covid. Rapid fall in the mid-spring of 2020, markets (and the economy in general) have rallied over 25% since then. Going back to the Spanish flu, the same sort of thing can be discerned, albeit there is some significant confusion in the data because of the juxtaposition of the flu and the end of World War I. However, generally speaking, throughout the period that the Spanish flu was pandemic, markets did just fine.
So, let’s all take a cleansing breath. War and disease simply don’t seem to have cut it.
On the other hand, we have witnessed events during the past century that have ravaged economies. In 1925, Great Britain shockingly attempted to return to the gold standard at pre-war parity. This was apparently, in significant measure, the result of pique over not being the Empire it had been in the 19thcentury. The resulting riptide in appreciation in the value of the currency, obliterated its international trade advantages and caused a deep recession, all in the name of British pride. The UK didn’t abandon the gold standard for good until 1931. A large period of stagflation resulted throughout the late 20s. The government finally abandoned it in an effort to address the Depression era conditions in the early 30s. In the silver lining department, the wrong-headed embrace of the gold standard in the mid-20s caused the UK to largely miss the roaring part of the 20s and therefore the Depression didn’t feel all that bad in England. Comforting, huh?
Next, of course in terms of governmental policy induced financial disaster is the Great Depression. We hardly need to spend time thinking about how truly wrong-headed and inadequate was our government’s (and most other governments around the world) monetary and fiscal response to collapsing demand and depression. President Hoover didn’t get a second term for good reason.
Next, let’s move onto the late and much revered Paul Volcker’s actions in crushing inflation at the Fed in 1982. At the time, inflation was rampant and the economy was struggling with something that today continues to frighten us: Stagflation. The Fed killed off inflation in the course of a year, driving interest rates to unprecedented high levels. (Something of which I have personal experience because I bought my first house around then and had a 13% mortgage…yikes!) But Mr. Volcker’s actions were not the stuff of a foot fault, but an intended policy that provided an intended result. Hardly the makings of a black swan.
The Great Recession of 2007-2008 surely does qualify for a self-inflicted black swan merit badge. A product of truly horrible governmental housing policy encouraging and enablinga market bereft of common sense and committed to the folly that risk was ephemeral, assets always appreciated in value and residential real estate was always a beautiful thing put paid to the amiable economic conditions that preceded it. Watching this slow-motion tragedy unfold, the occupants of the regulatory heights did get it right, after the fact, and ameliorated a truly deep and horrid recession, but even that was perhaps too little and too late. It’s called the Great Recession for a good reason.
Let’s take a brief side trip into the 1974 Arab Oil Embargo. This is the only candidate in my governmental-induced economic disaster data set not the result exclusively of domestic misadventure. The Oil Embargo did usher in a multi-year recession that was deep and painful. While it came on the heels of the collapse of the Bretton Woods Monetary System and a Treasury- abated US devaluation, it was pretty clear the oil spike wore the black hat here. In a similar vein, one might speculate that while Russian adventurism in Eastern Europe might itself not quality as a trigger for economic disruption, cutting off natural gas to all of Europe as part of a tit-for-tat sanction exchange could be a contender. Maybe we have to put Ukraine back on the worry list.
Where does that leave us in early 2022? I was initiallymost worried about geopolitical risk because it seemed to abound and I am becoming increasingly certain that we will have a very hard time dodging all of these wannabe geopolitical black swans for another year. But on balance, having looked at the historical record, I guess I am not as anxious about those geopolitical disruptions. So, Putin takes some or all of the Ukraine, the West either finds, or can’t find, its courage, but either way it’s hard to see something radically changing the calculus of the US or the world economy (albeit sanctions swapping remains a possibility). Taiwan? Seems more unlikely, but certainly not impossible for something to go wrong there. A new provocation from our chubby friend running North Koreagoes wildly wrong? Maybe. The Mideast never ceases to be a pot on the boil, but again, never ceases to be a pot on the boil.
If past is prologue, it’s hard to see how any of these events,in and of themselves, would materially derail the US economy(and for our very limited purposes here, that’s all I care about). Oh sure, there could be a bunch of things that could clearly make a difference. What if Covid metastasizes into something that gives us a 1348 moment? That would do it. Just for fun, go see Don’t Look Up in the theatres right now. It’s a pretty good movie in a Dr. Strangelove sort of way and certainly life-extinction events would qualify as a black swan. Albeit to the good, while life extinction events and other globe-girding,manmade or natural disasters could put paid to the world economy, it’s unlikely that I will have to say I’m sorry.
Where this all leads me is to really refocus my anxiety on fiscal and monetary misadventure…self-inflicted wounds done with the best of intentions and often with an almost willful disregard about the reality of imperfect knowledge, unintended consequences and unexpected externalities. Therefore, subject to a slight demure with respect to extinction events, I suggest we can stop obsessing on dictators and disease and focus our attention in a laser-like way on the potential of boneheaded policy decisions of our own government and the occupants of the regulatory heights.
What is really frightening is that some of those policy mistakes may have already been made, but the butcher’s bill has not yet come due. Does anyone really understand the mid to long term economic consequences of the vast expansion of the money supply and the Fed’s balance sheet as part of our muscular response to Covid? How about our nearly $30 trillion debt overhang? Is the continued management of the shape of the curve by the Fed and consequentially management of interest rates okay, or it is a problem? Will they now announce Fed prescription for interest rate hikes and a slimming of the balance sheet work as advertised?
Let’s close out our stroll through things to worry about with a look at the regulatory sensibilities of the current administration. What policies might be implemented with an administration suffused with progressive instincts endeavoringto act in a muscular way in the service of social justice, climate change, and fairness? Perhaps if all or much of that agenda is actually implemented (something that is far from certain at this point) we will see a bit more regulatory friction in the financial sector. Friction may result in an increase in cost, decreasedefficiency, decreased access to capital and a material increase in the cost of that capital. But surely our markets would survive that. It’s sort of more of the same.
But if these policy prescriptions…either individually or collectively trigger something meaningfully worse? Except for the talking heads of Fox News, that doesn’t seem likely. However, overshoot is always possible. We have a long history of well-intended policy prescriptions that turned out to be wrong-headed, policies that even while meeting their intended goals, triggered sufficient negative externalities to cause material damage to the economy. Moreover, given the increasingly massive size, breadth and power of our federal government, policy mistakes at the regulatory heights will be magnified because our government simply has more control over the economy than it had in the past.
It all bears watching, doesn’t it? I wish I could propose some “tells” here, something observed that would tell us that the calculus was changing and give us a heads up that things might go terribly wrong (like, for instance, the thought piece from Professor Omarova, the president’s withdrawn candidate to run the OCC, who suggested that banks be nationalized and made part of the Post Office! Yikes!)
But I can’t do that right now. So, we all needs to be heads up (and remember to support our PACs and trade organizations in their efforts to protect our markets.)
Look, my musings hardly constitute a scientific analysis of the historic record and please, if you have written a 100-pagedissertation on any of these events and are deeply distressed by my sophomoric analysis, just don’t bother to tell me.
Net/net, I can return to where I started a few weeks ago and confirm my relatively sunny analysis of 2022. I’ll take off the table my caveats regarding nutty dictators and germs, but I do have to double down on the possibility of fiscal or monetary misadventure.
Remember to call me if it all goes casters up and I promise to be dutifully remorseful and contrite.