The 21st century is almost a quarter old. Over that span there have been three distinct shock and awe moments for investors, 9/11, the collapse of Lehman Brothers, and the onset of Covid-19. The stock market reacted in a sharply negative fashion each time. Away from Wall Street, Americans seemed to freeze in place. After 9/11 we collectively mourned and froze in fear that the horrific events of that day were a start, not the end to such violence. The economy was weakening for some time leading to that fateful weekend when Lehman Brothers failed, Fannie Mae and Freddie Mac were absorbed into the Federal bureaucracy, Merrill Lynch was shoved into Bank of America and AIG almost collapsed. It was the events of that weekend that pushed the Fed to pour money into the economy and Congress to pass TARP to fund “shovel ready” projects. In early 2020, Covid-19 changed our lives almost immediately, both mentally and physically. By March, the whole nation was virtually shut down. The economy stopped.
Today, a shock and awe moment appears to be happening again. As a nation, we voted to support less government, less regulation, and the use of tariffs to both raise revenues and to facilitate the changes necessary in government. But few expected the pace of change to be so violent. No one surgically dismantled the regulatory burden or unnecessary Federal expenditures (of which there is a lot!). Instead, we got Musk with his chainsaw and a President who just tripled the price of your favorite French champagne. You see the reaction on Wall Street. What we don’t see yet is the commensurate change in reported data. But you will.
People are suddenly scared. Lower end consumers were struggling to make ends meet before Trump took office. Now higher end consumers are changing buying patterns as home sales fall and their IRAs tank. Businesses don’t know how to respond to tariffs given their on today, off tomorrow nature. Maybe that’s Trump’s style and maybe it will be a winning formula in the end. But no one can see the end today. And so, we freeze in place.
Both Trump and Musk speak in hyperbole. They exaggerate. Courts have tried to slow things down. Many laid off workers are now back at work, at least for the moment. There remains sound logic for Trump’s goals. There are too many regulations. The Federal bureaucracy is bloated. But when events move too fast, people don’t know what to do. So, they don’t do anything. They froze after 9/11, after the fall of Lehman, and while Covid-19 was placing all of us in quarantine.
So, how did we recover? 9/11 happened as the economy was decelerating anyway. The stock market was still trying to recover from the bursting of the Internet bubble. But over the ensuing months, President Bush retaliated against Afghanistan and Iraq, and America slowly regained some confidence. The Fed cut rates which stimulated a strong rebound in home demand. After the fall of Lehman, Congress passed TARP and the Fed flooded markets with money. It took some months for green shoots to emerge, but they did. Within six months the Great Recession was over. We all quarantined ourselves in the late winter of 2020 but slowly we started to come out of our cocoons in spring. The Federal government again flooded markets with money and within just a couple of months the bear market was reversed.
We are in another shock and awe moment today. It would be nice to think that Friday’s rally was the end of any correction. But in the three prior periods I just mentioned, there was a catalyst to bring the moment to an end. In 2002, the U.S. went after the bad guys obliterating al Queda in Afghanistan and taking down Hussein. The Fed cut rates to stimulate spending. In 2008, massive relief from Congress and the Federal Reserve planted the seeds for recovery. In 2020 there was a clear bottom when everyone went into lockdown. Almost by definition, that had to be the bottom. How could economic activity get worse than when we were all quarantined? Again, Congress and the Fed stepped in big time.
But today we aren’t at that moment, at least not yet. Trump isn’t wrong to attempt to reduce the size of government. Federal deficits are 7% of GDP and will keep rising if not addressed. That is a road to disaster. Raising revenues might help but the real issue is containing expenses. To bring the cost to service debt down, government spending has to be reduced by over $1 trillion. The biggest chunks are likely to come from defense and Medicaid. Defense Secretary Pete Hegseth has been instructed to cut spending from existing programs by 8% per year. It can happen. Medicaid can also be reduced by hundreds of billions of dollars by eliminating fraud, enforcing work requirements, and shifting burden back to the states. Yet we all know that stating a goal in Washington and achieving cost reduction are two very different issues. So far, the administration has talked the talk. Now it is time to walk the walk.
Cutting costs and increasing tariffs are short-term headwinds. Wall Street isn’t likely to embrace the back side of the process until the efficiencies that result from a streamlined government and a smaller debt service burden begin to become more evident. Markets don’t move in a straight line and perhaps Friday’s rally was the start of a temporary reprieve. But more likely we face a reduction in forecasted earnings and upward inflationary pressure from the tariffs before any benefits are evident. We are less than two months into the new administration and already approval ratings for Trump’s handling of the economy are at or below any level during his first term in office. Simply saying “trust me” isn’t going to provide much comfort.
It isn’t just the stock market that is moving in violent fashion. The dollar has been falling steadily since Inauguration Day. European equity markets are rising as ours fall. Governments overseas see the U.S. as a less reliable security blanket. As a result, they are taking steps to be more self-sufficient, especially for their own defenses. So far, there has been more talk than action but the belief is that the world order is changing and our allies worldwide need to adjust. The weakness in the dollar actually provides a benefit to Trump’s game plan by making U.S. exports cheaper and imports more expensive before incorporating the impact of tariffs.
All of this reconfiguration is just in its embryonic stage. There are few signs yet that the Trump administration is slowing its pace of new pronouncements. Not all have economic impact, but all are designed to shake the tree, reinforcing, at least for the moment, our collective concerns over the ultimate outcome. Overseas, adjustments are in early stages as well. The war in Ukraine drags on without solution. Ditto in the Middle East. All these concerns tie together.
Tomorrow and Wednesday, the Federal Reserve’s Open Market Committee (FOMC) meets. No one expects a change in interest rates. Inflation is still above target, the unemployment rate is barely above 4%, and data suggests the economy is still growing although the growth rate appears to be decelerating. What investors will fixate on are (1) Chairman Powell’s post-meeting comments that may suggest a change in the likelihood of future rate changes, and (2) the dot plots of forecasts of FOMC participants. Will they present a more pessimistic outlook than in December when the last set of dot plots was issued? Might there be a faster set of rate cuts should the economy weaken more than previously expected? Rate cuts are sometimes viewed as Wall Street’s crack cocaine. Lower rates are stimulative. But there is a fly in the ointment. Long-term rates reflect inflation expectations. What investor wants to accept a lower current return and get paid back with ever cheaper dollars ten years down the road? While the short-term rates the Fed sets are stimulative, parts of the economy, particularly housing, are tied to long-term rates. The Fed realizes that deficits of 7% of GDP or more are a road to ultimate disaster. Markets are starting to become concerned as well. Note the rebound in the 10-year Treasury yield the past two weeks while the stock market was tanking.
For a sustainable recovery in the stock market, investors need to see a path ahead that shows greater productivity, less government interference, inflation moving toward a sustainable 2% target, and better growth trends. The Trump administration suggests bold cuts early will set the stage for significant improvement later. One can dispute the way Washington is going about effectuating the changes without challenging the goals. Right now, however, there still lacks clarity whether the game plan is starting to work. We know consumer confidence has been shaken. We see it anecdotally in forecasts from large retailers to future airline bookings to the pace of home sales. We need to see green shoots which show that steps being taken are beginning to have positive impact. Few are apparent right now.
Fixing something broken isn’t easy. A lot of the pain happens first before the benefits of repair become apparent. Stocks have been fully valued for some time. The euphoric Trump rally after Election Day was misplaced. Investors forgot the necessary up front pain. Now we see the pain. Moods that have flipped from euphoric to despondent overexaggerate in both directions. Recession isn’t inevitable but possible. Cabinet Secretaries have their directives. They are to right size their departments, shrink government, eliminate extraneous regulations, and rebalance expenses with revenues. If that can be done effectively, we will all benefit. Add in the future productivity gains emanating from artificial intelligence and there is a very possible rosy path ahead. Getting there, however, won’t be pain-free. Looking through the lens of equity investors, it doesn’t have to be a straight path down. A lot of the readjustments have already taken place, particularly in the tech sector. As noted last week, some of the high-profile names are suddenly cheaper than Wal-Mart and Coca Cola. Market corrections and bear markets offer the best buying opportunities. Be patient. Don’t panic. There is always light at the end of the tunnel.
Today, Olympian Katie Ledecky is 28. Kurt Russell turns 74.
James M. Meyer, CFA 610-260-2220