On Deliberate Asset Deflation And The Fed

(This article was co-produced with Hoya Capital Real Estate.)

Likely, you are already licking your wounds as you ponder the shape of your portfolio.

As I write this, both U.S. and foreign stock markets have experienced deep, and sustained declines. As of last Friday. May 20, the Dow Jones Industrial Average had declined for 8 consecutive weeks, and both the S&P 500 and Nasdaq indexes for 7 consecutive weeks. Ironically, the Dow, which includes mostly mature U.S. companies, is “only” about 13 percent below its most recent peak. The technology-heavy Nasdaq composite index entered a bear market, a decline of 20 percent or greater from its most recent high, all the way back in March. Finally, only a late-day rally last Friday kept the S&P 500 from also officially entering a bear market.

While, as a recent retiree, I manage my investments fairly conservatively, my portfolio was down some 10.58% as of Friday’s close.

What to do? With the S&P 500 briefly dipping into bear market territory in the middle of the market session last Friday, is it time to “buy the dip” one more time? In this article, I will share some recent information that argues that there may yet be more downside yet to come, and that caution may be in order.

To be clear, this is not a “sky is falling” article. But it will be a reminder to review your personal asset allocation and risk tolerance.

Asset Inflation – How Did We Get Here?

In the title of my article, I referred to the Fed and “asset deflation.” Clearly, the implication is that there has been a period of asset inflation. How did that come about?

The total story can get a little long and complex but, for purposes of this article, we will oversimplify just a little. Following the Global Financial Crisis, or GFC, in addition to lowering short-term interest rates to zero the Fed engaged in what is known as quantitative easing (QE). This involves an unconventional monetary policy in which the Fed deliberately purchases assets such as longer-term government bonds and mortgage-backed securities (MBS). The effect of this is to increase the money supply, as well as hold down longer-term interest rates.

On top of that, as a result of COVID-19 bringing the economy to a screeching halt, more stimulus was injected, with the goal of helping businesses keep workers on payrolls and to ease the impact of layoffs. Most commentary that I have read applauds the Fed for these efforts, noting what could have happened had they failed to do so.

However, all of this stimulus was not without consequences. A significant one was that the overall money supply was greatly increased. This is represented in the below graph of what is known as the M2 money stock. In short, this represents money available for spending or saving. As you look at the graphic, please take note of the fairly sharp rise since the end of the GFC in 2009, and what might be described as a meteoric rise in 2020.

Clearly, then, there is now a ton of money in the system. Typically, this leads to inflation, as more and more money chases fewer and fewer goods. And yet, for quite some time, inflation was extremely tame. How could that be the case? Take a look at the next graphic, which charts what is known as the “velocity” of that M2 money stock.

Here is how that relationship is explained on the Velocity of M2 Money Stock page from which the above graphic is taken.

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time . . . providing some insight into whether consumers and businesses are saving or spending their money. (Italics mine)

Please focus on the words I italicized. If a dollar is spent, say, 10 times over a designated period of time, that means lots of goods and services are being bought and sold. Someone pays a contractor for a home improvement. The contractor, in turn, buys some furniture for his home, the furniture guy caters a wedding reception for his daughter, and the caterer buys a new pair of shoes. And on it goes. Money is flowing, the economy is moving. However, if that same dollar is spent one time, to purchase stocks, or buy a home, it is not moving through the economy in terms of purchases of goods and services, but rather is being invested in some sort of asset.

And that appears to be exactly what happened. On paper, this led to stunning wealth growth. The stock market experienced a sharp rise. So did home prices. Even more esoteric assets, such as the riskiest of stocks and various cryptocurrencies, were bid up.

Before we conclude this section, let me focus for just one minute on the sharp rise in housing prices. The severe market declines following the GFC caused a large portion of Americans to avoid stocks. As a result, not all participated in market gains. But, roughly 65% of Americans own a home, and this percentage has stayed relatively stable even during the period since 2009. As a result, many American households suddenly had much stronger balance sheets.

Deflating Those Assets To Fight Inflation

Ultimately, however, inflation did start to raise its ugly head. Again, the causes are many. The COVID-19 pandemic led to a drop in spending on services but a sharp increase in spending on goods, as people found themselves confined to their homes. Then came supply chain issues, Followed by the war in Ukraine. All of this has led to inflation that is currently running right around the 8% mark.

And that brings us back to beginning, with the recent market declines featured at the start of the article. Among other things, fears of a recession are rising. In fact, a recent article here on Seeking Alpha featured a call from Goldman Sachs that recession could push the S&P 500 index all the way down to 3,600, roughly an 11% drop from current levels.

Careful readers may notice, however, that the heading for this section doesn’t contain the word “recession.” Instead, it references intentional deflation of assets to fight inflation.

That concept comes from a recent note from Zoltan Pozsar, Investment Strategist at Credit Suisse. I recently wrote a fairly comprehensive summary of his note, but allow me to summarize the high-level points here.

Pozsar opens his note with some recent quotes from Bill Dudley, former President of the Federal Reserve Bank of New York. From the note:

[Per Dudley], if financial conditions don’t tighten on their own, “the Fed will have to shock markets to achieve the desired response”, that is, “it’ll have to inflict more losses on stock and bond investors than it has so far”. If that wasn’t clear enough, the former vice chair of the FOMC closed by saying: “one way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower”.

If you read that wording carefully, that’s a pretty stark message. There is reference to the Fed intentionally “shocking” markets, inflicting yet further losses on stock and bond investors, and “pushing” prices lower. Each one of those wordings signify deliberate intention.

Just how significant, though, might those stock losses have to be, to satisfy the Fed that they had inflation under control?

Take a quick look at the graph below, which displays the S&P 500 average over the past 5 years, and then I will share an excerpt from Pozsar’s commentary.

Here’s the excerpt:

At 4,000, the Fed does not seem content, and in the grand scheme of things . . .. At 3,500, we would have lost all of the post-pandemic gains in market wealth, but that level for stocks still feels like a put option, just with a lower strike price. At 2,500, we would lose not only all of the post-pandemic gains, but would eat into some of the pre-pandemic gains too. And if something indeed happened to the supply of labor post-pandemic (and some of that is wealth related), then to cool price pressures, maybe a pre-pandemic wealth level is appropriate indeed.

Visually, you can see that in the graphic. Right before the Covid-related collapse in March, 2020, the S&P average was in the 3,300-3,400 range. Clearly, Pozsar is suggesting that the Fed would be willing to let things fall at least that far. With his reference to a 2,500 S&P average, he also invites us to at least consider the possibility that the Fed might feel the need to do even more to truly crush inflation.

Here, though, is the last kicker. I closed the last section by briefly focusing on the sharp rise in housing prices, including the observation that, perhaps to an even greater extent than stocks, this may have strengthened the balance sheets of American households.

If, indeed, to get inflation under control, the Fed decides that it literally needs to deflate the household balance sheets that have become most inflated over the past couple of years, Pozsar seems to suggest that everything is fair game. Here’s one last excerpt, towards the conclusion of his note:

Our message today is this:

Consider the possibility that the Fed, on a singular mission to slay inflation, won’t rest in its pursuit of tighter financial conditions until yields shift higher, stocks fall more, and housing turns as well. (Italics mine)

Putting It All Together

As I mentioned at the outset, this is not intended to be a “sky is falling” article.

If Pozsar is correct, perhaps much of what lies ahead in the immediate future will be as a result of what the Fed intends. That would also imply that they could adjust course as conditions warrant.

Some of the most dire commentary I have read of late seems to say something along the lines of “Look how bad things already are, and we’ve hardly started with the interest rate increases, or QT.”

However, in the graphic below from FRED, take a look at the effect of what the Fed has already done on 30-year mortgages.

One of the tools the Fed has at their disposal is to talk about their intent. While it is true that we have only had 2 interest rate increases so far, cracks are already starting to appear in the housing market, as the effect of sharply rising 30-year rates begins to be felt.

At the same time, consider this. What if, just what if, the S&P 500 fell to even 3,000, roughly 25% below current prices, and the price of your home simultaneously declined by 10-20%?

Clearly, the answer to that question will vary by investor, depending on a variety of factors, including time horizon. I’m sure you would agree, though, that it is a worthwhile exercise to at least ponder the possibility.

One last thing, before we leave each other. Jerome Powell was just confirmed by the Senate for a second term. A recent CNBC article announcing this confirmation concluded with this paragraph:

In a rare digression last week, Powell addressed the public directly and said the Fed is deeply committed to bringing prices down and will use all the tools at its disposal to do so.