I can see surfers from my house in the winter, lining up in wait for the big wave. Sometimes it is a long wait, and many give up and go home. The ones that stay in the water eventually get rewarded, but for many, it is a pyrrhic victory as the wave overpowers them and they end up straight back in the sea, many of them bruised, if not literally, at least figuratively. There are some who manage to ride the big wave, sliding graciously towards the beach, beaming with pride, and basking in the limelight of the few spectators awaiting them on shore.
Many investors in financial markets have been waiting for the ‘big one’ ever since the 2008 GFC. Few have lasted with their portfolio intact since then, courtesy of ‘markets can stay ‘irrational’ longer than you can stay solvent’. Rightly so, a lot of things have changed since 2008 on the regulatory side (QE for one), on the technology side (access to markets), and on the investors’ side (direct retail participation). Maybe the market has not been irrational after all: it has been impossible to get a financial crisis purely from stretched valuations – there are always more buyers than sellers, and there is always a rationale for why ‘things are different this time’.
Unless the markets hit the limits of the real-world resource availability. Since the 1970s, recessions have always come after a financial crisis, which hits the consumer and causes demand to slump. And central banks (the Fed at least) have always responded by cutting rates. Covid was probably the first recession in the modern era, which was caused by a combination of supply-side and demand-side factors. It did not last because governments around the world implemented massive fiscal stimulus to offset it. What we are seeing today is the first proper supply-side crisis since the 1970s. And it is big. In fact, the oil shock is bigger than all the 1970s oil shocks taken together1. And this time around, government fiscal coffers are empty, and central banks’ hands are tied – not easy to cut rates facing an inflationary tsunami.
So, this could be the big one. The level of investors’ complacency is certainly high. Judging by sell-side commentary, while hedge funds’ gross exposure is down, it is still quite elevated by historical standards. Real institutional money has not started reducing exposure in earnest, and retail is still buying, though much less than a month ago. This is certainly reflected in some financial market prices: US equities are down just 8% from their all-time highs, and credit indices have widened only half as much as post-Liberation Day last year.
