Despite the seeming universality of the problems faced by both the U.S. economy and the stock market: the threat of recession amid record high inflation, the problems facing them are of a very different nature.
As for the U.S. economy, the country is experiencing a severe bout of pandemic inflation; pentup demand is facing a huge shortage of everything from workers to gadgets. Inflation is eating away at economic growth, driving up prices and negating wage growth. But some of the conditions associated with the pandemic, such as supply chain disruption, are already normalizing. And there is a chance that the economy will still be able to solve the problems of the last 2 years without falling into a full-blown recession.
Stock market turbulence is different in nature. The market is going through a brutal correction that has been taking shape for more than 10 years, and it seems only natural for it to fall from a superhigh level. Sooner or later the “bubble” that had formed in the market had to burst as interest rates rose. And the only factor that remained unknown was how severe the decline would be. Now inflation, which has hit the economy, has prompted the Federal Reserve to raise interest rates faster than Wall Street anticipated. That is why the market is in an unprecedented decline, with no bottom yet in sight.
It does not matter whether the recession is a technical one or a factual one, because – as everyone admits – a bear market has arrived.
The inflation that the rest of the world is experiencing is due to both supply chain failures and chaotic housing demand, labor shortages and geopolitical factors.
As you know, the higher the inflation, the harder it is to get rid of. That’s why the Fed is taking drastic measures: it raised its key interest rate from 0% to 4% in a few months. By raising the rate, the Fed hopes to make access to credit more expensive for people and companies, helping to slow the flow of money and reduce demand for homes, cars, and jobs. If the economy slows down, demand will also flatten out and lower inflation.
There are already signs that the economy can weather inflationary pressures, as job growth remains steady, average hourly wages have also risen. Consumer spending remains flat, and many businesses expect a strong holiday shopping season.
In a note to clients, analysts at Goldman Sachs (NYSE:GS) said private sector finances are healthier “than on the eve of any U.S. recession since the 1950s,” which helps “increase the chances of a soft landing.”
However, the stock market situation is not so optimistic. Investors rushed to buy up growth stocks, especially tech companies, because they grew the fastest due to nearzero interest rates. Not surprisingly, even those companies that weren’t making money could easily borrow, and investors were willing to wait for companies to turn a profit while their stocks could show growth. Nowhere was this business model more relevant than in Silicon Valley. Everything from Uber (NYSE:UBER) to DoorDash (NYSE:DASH) to Carvana (NYSE:CVNA) to Tesla (NASDAQ:TSLA) was growing, and companies that weren’t making money could not just survive but thrive.
In 2018, it became clear that this bubble would burst in earnest sooner or later, but the Fed’s attempt to gradually raise interest rates led to a systematic collapse of these oversold stocks. The economy was strong enough to withstand price spikes: unemployment was historically low and inflation was moderate, but the stock market had its worst year since the financial crash of 2008.
The pandemic broke a healthy trend that suggested the stock market would learn to live with a slightly higher interest rate in a stable economy in 2020. To support the economy, the Fed went back to its post 2008 strategy. This time, retail investors joined Robinhood (NASDAQ:HOOD) en masse and bought up all sorts of shell companies, inflating the bubble even more.
And similar to what happened in 2018 when the Fed started raising rates, the stock market fell, but this time even harder: the S&P 500 has fallen 17% since the rate started rising, and the NASDAQ has fallen 29%. Experts estimate that for the market to retu to pre-pandemic levels, it must continue to decline by 30 40%. We can expect that despite Wall Street’s best efforts to convince everyone (and themselves) that the Fed will pause and the bear market will end, Powell will not stop because the health of the economy is at stake. And that means stocks can (and will) fall.