Over the past week global equity markets have corrected substantially, with some gauges falling more than 10% in just two trading days. Aside from a brief panic at the start of the COVID-19 pandemic, we haven’t experienced this sort of market volatility since the Global Financial Crisis of 2008-2009.
There’s not currently much to suggest that we’re headed for an extended recession. This appears to be more of a case of markets that had risen too far, too fast. True, there are some asset classes that may experience longer-term pain, such as commercial real estate. Last week’s corporate earnings came in weak. And there has perhaps been too much froth in thematic stocks, such as chip maker NVIDIA, which has been on a remarkable rise over the past year due to excitement around the potential impact of generative AI. But the economy overall still appears quite healthy.
We do think — for the first time since 2021 — that the Fed will begin to cut interest rates. In fact, if market volatility continues, we believe there’s a possibility of an emergency rate cut in advance of the Fed’s next scheduled meeting in September. If short term rates start to fall, it’s all the more important that you keep close tabs on your cash in the bank to make sure it’s always earning the highest rate. For the past 10 years, Max has consistently delivered the highest rates available on FDIC-insured deposits.
While early on in the pandemic, the inflation we experienced was due to supply-side constraints, the inflation that has persisted for the past two years has been more driven by the demand side. American households, fueled by stimulus cash and the reduced costs of living associated with remote work, have been on a shopping spree. Not so much in terms of extraneous purchases, but rather a simple willingness to pay more for everyday goods.
A simple take-out lunch that might have been $5-8 dollars a few years ago can now cost $18. Part of the increase is driven by increased labor costs, including increases to the minimum wage. But part of these price hikes is due to consumers’ elasticity of demand. If a store owner raises prices and shoppers still buy their products at that higher price, the shopkeeper’s incentive is to raise the price yet further and see if they still buy.
Frictionless digital payments have made it easier for consumers to pay more without giving much thought to their actions. And changes in behavior, such as the widespread use of personal delivery services such as GrubHub and Uber Eats and the proliferation of prompts for tipping at the cash register have driven up costs even further.
The only way to end this cycle of escalating prices is for the consumer to revolt, and typically that’s only possible with a recession that forces consumers to cut back. This is why the desired “soft landing” is so elusive. It’s hard to convince people to cut back spending or to push back on retailers until they’re encountering the sort of economic pain that forces them to cut back spending en masse.
A rapid rise in the equity markets can contribute to the wealth effect — people flush with unrealized gains feel a greater willingness to spend those unrealized gains. Similarly, a rapid drop in equity markets can cause consumers to cut back, even if their take home pay hasn’t yet been impacted. And so a substantial correction in the equity markets may help stem the cycle of upward pressure on prices.
Data from global consulting firm Capgemini show that the average high net worth household in North America keeps 24% of their liquid assets in cash. We’ve long been interested in this data point — why do people hold so much cash when historically equities have far outperformed cash as an asset class? We believe the reason is twofold.
- First, families sleep better at night knowing that in the event of market volatility, job loss, extraordinary medical illness, or other unforeseen circumstance, having a substantial cushion of cash will enable them to weather whatever storm they might face.
- Second, holding this amount of cash provides the psychological cushion to avoid panicking and selling when markets turn volatile. After all, most financial plans are built around multi-decades long strategies. Whether the market rises or falls in any given day should have zero impact on your long-term strategy. But humans are emotional, and much as a rise in the stock market can make you feel wealthy and contribute to the wealth effect, a drop in the market can wreak havoc on our psyches, prompting irrational behavior and panic selling.
Some might argue that a third reason to hold cash is to be at the ready, so that you can buy into the market precisely when others are selling. This approach is part of what has made Warren Buffett so successful — having large amounts of cash on hand so that he can be the buyer of last resort. But few people are good at timing the market, and statistically, those that are may simply be more lucky than smart. Investors who are disciplined about investing and pursue a strategy of dollar cost averaging have tended to do well by enforcing a program of buying even while others are panicking and selling, capturing the long term gains that the equity markets have delivered over many decades.
Market volatility may be back, and the easy money of the past two years may be fleeting, but with some luck we’ll finally return to ‘normal’, with short term rates in the 4% range, mortgages becoming more affordable, inflation brought down to a more manageable 2-3% range, and equity markets returning more modest sums in line with their long-term averages. Financial advisors — who have lived through many market cycles — will help clients focus on their long-term plans and stay the course.