I'm very worried about market fragility & downside risks in 2021...
I'm very worried about market fragility & downside risks in 2021...
My question to Goldman Sachs Chief Economist Jan Hatzius on likelihood & magnitude of downside risks. Will the system collapse in 2021? It's a problem that buying stocks feels like buying Bitcoin...
I have written many emails about why markets will likely continue to go up for the foreseeable future, but lately I have not been feeling very good about where we’re headed, and the contrarian part deep down compels me to find reasons against my existing beliefs. “Are we too confident about this 2021 global recovery story?”
I was at Princeton Griswold Center’s spring symposium this past weekend, and I asked Goldman Sachs Chief Economist Jan Hatzius the following question:
I would love to hear your thoughts on both the likelihood and potential magnitude of downside risks/consequences. Do you think the markets are in a very fragile place today? In the sense that we’re seeing, from my vantage point at least, scarily unanimous consensus that the markets will go up in 2021. But this consensus is contingent on some very optimistic assumptions:
We will have a speedy economic recovery;
We will not see inflation anytime soon, and even if we do, it will be transitory;
The Fed will stick to their current script to support the market without being rocked by short-term market volatilities;
And more…
But the issue I see is that we’re already at historical levels of low interest rate, high QE, high deficit, high degree of financialization & inequality. The Fed has already used all its tools to support market function and entangled itself with the markets to the fullest extent.
So, what would happen if things don’t go as smoothly as we expect them to be? Say one of the above assumptions fail to deliver, or some completely exogenous shock (another Black Swan event) hits the system that will deviate us, even just slightly, from this beautiful script we’ve currently written for ourselves. If that happens, it seems that we don’t have many policy options left. Will the system collapse? How severe would the consequences be if any of the downside risks actualizes? Am I too pessimistic?
What I was trying to get at is: everyone is optimistic and feeling good about 2021. Whether you’re talking about the financial markets or the real economy, vaccine rollout or consumer spending, everything looks absolutely fantastic. Goldman is one of the cheerleaders:
It’s reasonable to be optimistic, especially given the recent passage of the $1.9 trillion stimulus package, as well as the Federal Reserve’s unwavering support for the markets, but what if something goes wrong? I asked Jan that question mainly to try to figure out whether professionals are spending enough time reflecting on the possibilities of major downside risks and market fragility.
And I’m not trying to be a “permanent bear” who constantly just says that markets will crash and only gets things right every once ten years. I outlined some of my worries in a recent email “We came very close to a market accident last week…”, and here’s my overall logic:
Prices are increasingly detached from fundamentals and become more driven by narratives. Whatever the Fed says or does, they immediately risk being seen as too hawkish/dovish. This is why the Fed has to stick to the script because any deviation from their current script would make them more entangled with the markets and harder for them to exit its current set of policy interventions down the road.
There is almost unanimous consensus in the economic policymaking community and financial market participants that the $1.9 trillion won’t cause lasting inflation, but they also admit that inflation in 2020 will likely be around or even higher than 2%. This means we’ll probably see some kind of price level increase by the end of this year. Sure this 2% inflation likely won’t be lasting, but the danger is that the market won’t be able to tell the difference between price level change and real inflation coming in, and that could lead to more disruptive market dynamics.
When markets have become inherently more volatile and dependent on relatively minute changes in certain metrics (such as whether the 10-year Treasury yield goes up by another 0.25% or whether price level changes a bit more), that makes the whole environment much more fragile because any slight deviation from market participants’ previous assumptions would lead to dramatic volatility.
Short-term volatility should theoretically be fine, since noises will eventually cancel each other out in the medium to long run, but I am not very confident that absolutely nothing will go wrong. The likelihood of something goes wrong is not trivial.
Right now making money in financial markets feels very easy, and the biggest risk almost seems to be to not have some investment in the markets. This is analogous to a line of argument very prevalent in the Bitcoin community these days:
The case of Bitcoin is fundamentally different from investing in the stock market, which has many good companies that will perform well in 2021. So, one could argue that the fundamentals for stock markets are much, much stronger than that of Bitcoin.
However, at some level buying stocks almost feels the same as buying Bitcoin these days. Yes, the rational analysis actually does tell us that this is indeed a really good time to buy stocks because we have every reason to believe that 2021 will be a great year for global recovery. But, the underlying raw emotions that are driving us to go into the stock market – mainly the FOMO (fear of missing out) – are kind of the same whether we’re buying stocks or Bitcoin…
And if one’s investment decision is driven by FOMO rather than the belief in the fundmaental value of the underlying asset, then that by definition is a speculative bubble, and this is what I wrote in my previous email “OK maybe don’t buy Bitcoin NOW…”
I guess the punchline is we ought to be more thoughtful and reflective about what are the factors driving us to make investment decisions. Is it the belief in an asset, a vision, a narrative? Or is it fear, greed, hunger? Maybe a combination of all of the above?
We’re in a really weird phase right now. With the massive stimulus and optimism rushing into our economy, I think everyone is a bit overwhelmed. In such these exuberant times, I get confused and worried. I am still very puzzled by my long question above…
I have not been able to write too much lately partly because of academic commitments but also mainly because I’m trying to take a break from my over-consumption of media. I’m working on some longer pieces, such as on the ongoing inflation debate (whether the $1.9 trillion stimulus is too big and would lead to rampant inflation), as well as some market updates, which I’ll hopefully release soon.
By the way, here is a good podcast that Jan did on Bloomberg’s Odd Lots back in December. And his recent appearance on Bloomberg surveillance also gives you a good idea on where he stands on the upcoming recovery:
Disclaimer: Needless to say, my emails are just casual commentaries. I try my best to write them thoughtfully and with care to provide some alternative perspectives on various issues, but please do not treat them in any way as financial advice for your own investment.
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