Resetting the Market Provides Continuing Shock Therapy

It was, in the words of one economist, “a tough day across risky markets” when the S&P 500 on September 15th lost 4.7 per cent – its biggest one-day drop in seven years. “An ugly day in stocks,” he added. Another market observer agreed that “locusts” save victims with global stocks.

The verdict on the front page of this newspaper was frank. The headline declared “Wall Street Judgment Day,” complete with a portrait of desperate bankers in Canary Wharf.

If you thought something seemed a little off here, you’d be right. The shock to the markets was September 15, 2008, not 2022. Those desperate bankers were standing outside Lehman Brothers’ European headquarters and Bank of America had just swallowed Merrill Lynch while the global financial system was exhausted.

Fast forward nearly 14 years and history doesn’t repeat, but it certainly rhymes.

This time, on September 13, the benchmark S&P 500 index of US stocks fell more than 4 percent — a drop on a scale not seen since the Covid crisis began more than two years ago. The Nasdaq Composite did even worse, losing 5.2 percent. As strange as it sounds, the post-Covid recovery phase in 2022 is having ugly market moments as in the week Lehman Brothers told shocked employees “It’s over.” Even more weird: somehow, we got used to the hits.

This is probably because investors have had a fainting spell every time this year that US inflation data has turned out to be surprisingly strong. This week was no exception. US consumer price inflation rose to 8.3 percent for the month of August, according to figures released by the Bureau of Labor Statistics on Tuesday. That’s slightly better than the 8.5 percent figure for July. The problem is that analysts and investors were expecting a tamer pace of 8.1 percent, especially given the rapid decline in gasoline prices. The rate also rose 0.1 percent in August from the previous month.

Once again, this torpedoed the long-awaited pivot from the US Federal Reserve – the legendary moment when it decided to cut interest rate hikes that have been putting pressure on asset prices this year. Once again, optimistic critics are disappointed and the blows will continue until morale improves.

Traders now see a reasonable chance that the Fed will raise interest rates by a huge full percentage point at next week’s meeting. Anything less than three-quarters of a point would be a huge surprise.

BlackRock compares this situation somewhat convincingly with Knut, a polar bear. For those who have forgotten Knut’s story (me included), The Investment House reminds us that a newborn cub was rejected by his mother at the Berlin Zoo in 2006.

“The zoo keeper went up to raise him with the bottle. But some have argued that it would be better to kill the bear than to raise the humans,” wrote Jean Boivin and Alex Brazier. A media frenzy and widespread protests ensued, eventually saving Knut’s life. In our minds, central bankers seem to have some sort of “let the bear die” mentality right now (eg, read economics). It seems that they would rather just let the economy die to avoid any risks of declining inflation expectations.”

Rudely, as the economy is headed, your wallet will likely follow. It might be time to find a friendly park ranger, or some sympathetic protester.

The thing is, as all but the smallest polar bears are aware, this isn’t new. So why does the market panic every time it gets a reminder? “It’s a triumph of hope over experience,” says Trevor Greetham, Head of Multiple Assets at Royal London Asset Management. “If you said to any of us three years ago that we would look at 22 per cent inflation in the UK if it wasn’t for government action on energy prices, we wouldn’t have believed you. It’s a massive system change. People still want inflation to be temporary and temporary.” Not.

In addition to lower stock prices similar to 2008, all this leads to large swings in the dollar and in the more sedate government bond market. Some analysts fear that the old structural flaws in the debt market are becoming serious. Bank of America described cracks in US Treasuries as “one of the biggest threats to global financial stability today, possibly worse than the housing bubble of 2004-2007”. Left unchecked, quantitative tightening – the process of the Federal Reserve shrinking its balance sheet in an age of crisis – could be the factor tipping this market over the edge.

We shouldn’t all hope it isn’t, a lot of this technical stuff is white noise for non-professionals. But Gretham puts it simply delightfully: “Whether it’s Qt or just a colossal central bank blunder over the Covid crisis, it’s the same thing.” Hindsight is nice, but it is clear by the day that markets have been generously supported by central banks for far too long. Correcting this imbalance will continue to spark the ugly pullbacks and false bear market rallies that characterized the 2008-2009 crisis.

katie.martin@ft.com

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