Recent data from the Commerce Department reveals that the U.S. GDP experienced an annualized growth rate of just 1.1 percent in the first quarter of 2023, significantly lower than the anticipated 2 percent. This raises a pivotal question: has the economy already begun to contract?
As we await the Commerce Department’s report for the second quarter, set to be published in late July, the central inquiry becomes: How does a potential recession impact the stock market?
The upcoming Federal Open Market Committee (FOMC) meeting on May 2 and 3 is prompting expectations for a 25 basis point increase in interest rates, which would adjust the federal funds rate to a range of 5.00 to 5.25 percent. Many analysts predict this will be the last hike of this cycle, leading to a pause before potential cuts later in the year to counteract economic downturns.
Typically, interest rate cuts are viewed as bullish for stock markets and beneficial for the overall economy. However, at Economic Prism, we harbor some concerns about these forecasts.
We foresee a significant stock market correction that could drive major indexes down to unprecedented lows, coinciding with a reduction in interest rates. Here’s our rationale.
The last time the federal funds rate reached 5.25 percent was on June 29, 2006. The Fed subsequently maintained this rate for approximately 15 months, pausing before initiating a rate cut of 50 basis points on September 18, 2007.
The Dangers of Cheap Credit
When borrowing is inexpensive, it becomes easier for consumers, businesses, and governments to finance purchases that may otherwise seem extravagant. However, with a federal funds rate at 5.25 percent, tighter credit markets can lead to negative cash flow, resulting in unpaid debts and defaults.
The implications of cheap credit giving rise to poor quality debts do not surface immediately. Sectors that heavily depend on financing, like real estate and automotive, feel the effects first, while everyday necessities remain more stable in demand.
In June 2006, when the Fed held the federal funds rate steady at 5.25 percent, many economists felt relief, believing the worst had passed. However, on May 17, 2007, Fed Chair Ben Bernanke downplayed the looming crisis, asserting:
“The subprime mess is grave but largely contained. Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited.”
Little did he know, the housing market was deteriorating rapidly.
Fostering Financial Turmoil
Bernanke seemingly ignored the warning signs. When Bear Stearns collapsed in March 2008, he continued to project optimism, stating on June 8, 2008:
“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.”
Despite this optimism, Bernanke was simultaneously slashing the federal funds rate, bringing it down from 5.25 percent in September 2007 to a range of 0.00 to 0.25 percent by December 2008. He likely believed this would help rejuvenate the economy and uplift stock values.
However, when Lehman Brothers failed on September 15, 2008, the financial climate froze. Just days later, Bernanke and Treasury Secretary Hank Paulson sought a massive government bailout of the financial sector.
During an emergency meeting on September 18, 2008, Bernanke warned:
“If we don’t do this tomorrow, we won’t have an economy on Monday.”
Two months later, he initiated QE1, saturating financial markets with liquidity and breeding new uncertainties for the economy. Notably, while the Fed cut rates and implemented QE, the stock market did not flourish; rather, it dipped significantly.
In fact, the S&P 500 hit its peak at around 1,586 in October 2007 and gradually fell to around 1,200 by August 2008. Investors thought they were seizing a purchasing opportunity, assuming the Fed would manage a soft landing—a misjudgment of monumental proportions.
The S&P 500 free-fell to a low of 666 by March 6, 2009, resulting in a staggering 58 percent drop. While this period was painful, it also presented a historic buying opportunity.
Conclusion: Insights for the Future
Implications of the Fed’s Rate Hike Cessation for Stocks
In the lush mountains of East Tennessee, dense vegetation obscures any view of what lies beyond. In similar fashion, financial markets may be concealing deeper problems, echoing the uncertainties of the past.
Reflecting on Dennis Martin’s mysterious disappearance in 1969 in the Smoky Mountains, where exhaustive searches yielded few clues, we can draw parallels to the current market conditions. The Fed ceased rate hikes in June 2006; the S&P 500 continued to surge until October 2007, and the market didn’t fully bottom out until March 2009—18 months after the initial cuts.
“History doesn’t repeat itself, but it often rhymes.” Although the factors influencing the economy in 2023 differ markedly from those in 2008, echoes of prior stresses still resonate.
There exists a significant amount of bad debt today, exacerbated by elevated interest rates over the past 14 months. The commercial real estate sector is in distress, and pension funds are burdened by deteriorating assets. Additionally, the S&P 500 remains overvalued compared to historical norms.
Thus, the anticipated end of the Fed’s rate hikes does not necessarily signify safety; rather, it may mark the beginning of a challenging journey through turbulent economic terrain. If the Fed begins cutting rates in October 2023, it’s plausible the S&P 500 won’t recover until it reaches a low around April 2025.
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Sincerely,
MN Gordon
for Economic Prism
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