Find the Buoy Line

THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.

When I swim in Long Island Sound, I sight off buoys to help me navigate when the current gets squirrelly. I want to distill what I’m observing in markets to a few key mental buoys. I’ll limit the post to bullet points since many of you are likely already processing a lot of information.

Here we go:

• The financial markets are behaving similarly to how they did after 9/11, in early 2008, and during the COVID crisis: stocks are down, bonds are up, credit spreads are widening, and peripheral assets (like the Australian dollar) are falling.

• The cause of this market performance is an unexpected, large fiscal tightening. Fiscal tightening—raising taxes—mechanically removes money from the economy. Less money leads to lower prices, including for stocks. As the cost of goods rises, people have less money to buy other items, which reduces volume.

• The US generated unprecedented wealth over the last 100 years by participating in a global system defined by the rule of law and free trade. This system raised overall wealth but worsened income inequality. The Administration’s policies aim to redistribute wealth (narrow the wealth gap) by shrinking the economic pie. This mirrors the policies President Xi has implemented in China.

• The S&P 500 is currently trading at about 20x forward earnings, implying an expectation of earnings per share around 260. In a recession, the P/E ratio could drop to 16 or 18, and earnings per share could fall by around 10%, maybe more. This suggests that the S&P 500 could decline by approximately 30% from its current level.

• The Federal Reserve is expected to cut rates to 3% by 2026, about 130 basis points lower than current levels. The European Central Bank is expected to lower rates to 1.6% by next year, about 75 basis points lower. In a recession, the Fed could lower rates by 400 to 500 basis points, bringing the rate as low as 0.5%. The same applies to the ECB.

• The dollar is currently trading at 146 against the Japanese yen and is expected (discounted) to decline to 141 over the next year. In a severe crisis, the dollar could fall to 110 yen. The US imports about $1 trillion in foreign capital annually. If foreigners lend the US less money, the dollar will decline. In a 2008 style crisis, the dollar actually goes up.

• Unlike the COVID crisis, tariffs are a manufactured, man-made crisis. If the Administration reversed its tariff policies, the situation would largely resolve. However, the longer the Administration pursues these policies, the more the damage becomes permanent.

• When governments led by charismatic leaders make policy errors, it often takes years to reverse course. Typically, these reversals only happen when the leader is no longer in power. Examples include Putin’s invasion of Ukraine, Hoover’s financial policies during the Great Depression, Johnson’s handling of the Vietnam War, and Mao’s Great Leap Forward. In all these cases, the evidence of policy failure was obvious, but the leader did not change direction.

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