Flat market scenario

The last couple of weeks in the stock market have seen quite relaxed flatlining and at the index level the surface has been almost perfectly calm.

But the economic data has been a bit soft, with a few companies dropping a profit warning surprisingly quickly after the earnings season, such as UPM and Aspo. At the same time, investors are worried about the fast-approaching debt ceiling crisis, which at its worst could bring down the market and the economy.

Let's talk more about these issues in this post. First of all, let me remind you of the so-called 1946 scenario that I've brought up in these posts every now and again.

1946 scenario

When I attended the Berkshire Hathaway AGM last week, Warren Buffett made several references to World War II. He started investing in 1942, so the Oracle of Omaha is familiar with the era from that perspective as well. This made me think of bringing up the stock market's links to the late 1940s for the first time in a long time. At least at the top level of the economy, there are similarities in the way the economy was stimulated, and supply and demand went haywire. All resources were directed towards defeating the Axis powers. The military economy stimulates the economy in a big way, a bit like the pandemic recovery. When the war ended, the economy briefly went into a deep recession. As price controls loosened thereafter, inflation jumped sharply as output adjusted to expanding consumer demand.

Stock markets that had experienced a wartime boom collapsed by almost 30% after the war. The years that followed were spent flatlining under macroeconomic pressure. Earnings generally rose after the post-war recession, but stocks stayed on a horizontal trajectory for three years until a new bull market started in 1949. This graph juxtaposes stock market performance in the 1940s and today. Although those rhyme nicely, I'm not saying that we're repeating the same flat market. But this is a realistic possibility among others to consider.

Debt ceiling crisis approaching

Investors' attention is increasingly focused on the looming debt ceiling crisis in the United States. In practice, the debt ceiling should be raised as soon as possible, or else the federal government's little treasury will run out, public services will grind to a halt and debts will remain unpaid. As the US bond market is the hub of the global financial system, the impact would be significant. In a similar crisis in 2011, the stock market dipped by 20% and economic growth slowed sharply, even though the US avoided default.

There are different estimates in the media about what would happen if the US were to default. The effects of such a huge shock are impossible to predict, but it’s clear that if prolonged, the impact on the economy would be very negative and the uncertainty in the market would be palpable.

The US Congressional Budget Office estimates that the US public debt will reach 119% of GDP by 2033 if current trends in income and expenditure continue. Although the US has a massive borrowing capacity, endless borrowing isn’t possible even there without significant additional costs. This is why politicians want to reduce the rate of going into debt, but there is disagreement on how to do it.

I went through the debt-ceiling crisis and US debt sustainability in more detail in a post back in January. Virtually, only the estimate of the date of running out of federal money has been brought forward to early June, but otherwise the debt ceiling section of the post is still insightful.

In the market, the price to hedge against a US default has risen well above 2011 levels, raising some eyebrows.

The political debate around the debt ceiling seems to be inflamed. Last week, former President Donald Trump incited Republicans to plunge the US into default if their cuts list is not agreed. Earlier, another politician compared the negotiations to a knife fight.

Despite the fiery rhetoric, the threshold for not actually raising the debt ceiling is quite high. It has been done dozens of times before. One might well ask which politician wants to stand before the people and tell them about a crisis of his own making, when the debt ceiling was not raised because of bickering. At least that politician will be a former politician. Vast amounts of credit would be given to the United States, so the crisis is purely political.

For the investor, the potential volatility brought about by the crisis could bring interesting opportunities in solid shareholder value-creating businesses, unless politicians are serious about making a political kamikaze attack on the US economy.

Slight softening in the economy

The economic data have shown some signs of softening recently.

One of the bulls' key arguments for economic sustainability is strong employment and hence juicy wage growth in the US. Data on preliminary jobless claims released last week jumped above expectations at the weekly level to 264,000, the highest level since the end of 2021. Admittedly, one week's data can swing here and there randomly and to top it all off, it was later discovered that thousands of false unemployment claims had been made in one state as scam attempts and once you cleaned them out of the data, the rise in claims was much milder.

In addition, Indeed's rapidly updating job vacancy figures appear to be cooling in the US, but it’s difficult to say whether this is so much a weakening of the labor market as a normalization of the situation. There are still a record number of unfilled vacancies in the US.

The unemployment rate in the US has plummeted to a very low 3.4%. People who don’t have a job but are looking for work are counted as unemployed. Thus, new labor should be obtained by activating people who are not actively looking for work. In this graph, I have somewhat populistically equated the unemployment rate with the S&P 500 index. Not always, but often, a super-tight labor market and an overheated economy have led to a recession, and shares have taken a beating. While the world's most anticipated recession so far is a long time coming, it's worth being aware of the hot state of the economy that doesn’t always end well.



Secondly, economic problems show up last in employment data, so the stock market tends to slip long before employment. This has happened this time too, with the S&P500 peaking so far, a year and a half ago while the unemployment rate has only fallen further. However, in the 1990s, the stock market rose even though the unemployment rate rose at the same time. So that's not impossible either. A cooling of the current overheated labor market could be positive for equities in the sense that it would remove wage pressures and inflationary pressures.

This illustration also tells aptly the story that stocks are usually worth sticking with, even though cycles come and go. Good companies tend to push forward. Over the arbitrary 33-year period of this graph, the S&P 500 index has risen by +1,000% despite several recessions and crises.

Of course, weak industrial performance has long overshadowed economies around the world. Local industrial indices from the United States published in recent days have shown weaker-than-expected developments. Chinese economic data also missed expectations this morning after a strong first quarter.

Caution about the economy is also reflected in the bond market. The US 10-year bond, reflecting market expectations of future inflation and economic developments, has stubbornly continued to hover around 3.5%. Interestingly, market interest rates haven’t recovered from the small bank crisis in the spring.

However, the bank loan mass, which stands at just under $18 trillion in the US, so far seems to be recovering from its March slump. Moreover, the economy is supported by strong income growth and consumption. In this somewhat confusing graph, the annual change in the bank loan portfolios is juxtaposed with the annual change in household disposable income. Income in the US is around 20 trillion a year, so we’re talking about big figures in both. Unlike, say, before the financial crisis, income is now growing much faster than bank lending. In other words, the slowdown in bank lending from the pandemic period frenzy may not be so fatal for economic growth, at least not immediately.

Finally, I could bring up the expectations about the evolution of the Fed's rate hikes. Fed members vow to keep the policy rate at the current level of 5.25% for a long time as inflation cools painfully slowly, but by early next year the market expects the policy rate to be cut several times to over 4%. But well, future inflationary developments will determine this.

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