Soft landing no more! Recession is inevitable.

I started writing a post 2 weeks ago titled "Have we really dodged a recession?" So much has changed since then, that the post is now outdated. Here's another one explaining what's happening now.

Despite high interest rates and inflation, we saw resilient demand across the market for the first half of 2024. Unemployment remained at record low and the fear of recession had evaporated.

There was little explanation for this optimism. It was mostly credited to (or blamed on, depending on whom you are speaking to) the breakthroughs (or hype) around AI. Everybody was saying that we would have seen a recession at the start of 2024 if not for AI.

The Mag 7 stocks have been solely blamed for the rally but the fact is that SPX493 are also trading at much higher valuations than before. Crypto should not be affected by AI and yet we see a strong rally there too. Therefore, in my opinion AI has helped fuel the euphoria but isn’t the root cause of the market rally.

Instead the root cause is the amount of easy money in the market. Steep rise in salary, savings from the lockdown, government stimulus packages and change in spending habits have fueled the consumer demand and also flooded the stock market with a lot of liquidity. New investors have flocked to the market and they are often filled with greed and optimism.

But a perfect storm is brewing. The following inevitable actions will force an exodus of money from the stock markets over the next few months.

Japanese carry trade

Let’s start with what already happened last week already.

Japan is a country with very high debt to GDP ratio and one way to sustain the borrowing is by keeping interest rates low. For this reason interest rates have been very low in Japan. Investors borrow Japanese Yen cheaply, convert it to USD and use this to invest in assets such as US equity and government bonds. This is called the Yen carry trade.

Last week, Bank of Japan raised interest rate from 0 to 0.25 percent in a surprise move. This made $USDJPY fall steeply. This meant that investments in USD were suddenly worth much less in JPY and servicing the loans was more expensive. This forced investors to cut losses.

To be frank, this wasn’t even on my radar and I bet most people didn’t anticipate this either. That’s how perfect storms are formed when everything that can go wrong, does go wrong.

US interest rate cuts

We’ve already seen signs of dwindling demands from revenue misses and weak projections by AMZN 0.00%↑ BKNG 0.00%↑ ABNB 0.00%↑ and also increasing unemployment rate. To boost the economy, it is widely anticipated that the US Fed will cut interest rates by 25 bps in September, followed by more rate cuts before end of year. What impact that has on the stock markets isn’t quite clear though.

You’d expect that dropping interest rates would be good for real estate, but I anticipate that after the first rate cut the real estate market would freeze. Buyers will want to wait for interest rates to come further down in the coming months. This would hurt demand for appliances, furniture and all the things people buy for their new houses.

Meanwhile, government bonds become attractive when interest rates are anticipated to fall, so a lot of money will move from the stock markets towards government bonds.

Eventually after a few more rate cuts, the pent up demand for real estate will wake up and a lot of money will flow out to real estate investment.

US budget deficit reduction

The debt to GDP ratio has risen sharply in the US over the past years and they are running a very high budget deficit. Regardless of which party comes to power they would have to make hard decisions to reduce the budget deficit.

The Republicans plan to do this by reducing costs, while the Democrats plan to do this by raising taxes. Both of these actions are deflationary and reduces the amount of cash in the market.

Job losses

Dwindling demand due to all the above reasons will lead to falling revenues and job losses. This is the most recognizable aspect of a recession and would affect millions of people around the world. This is how the whole thing becomes a vicious cycle.

[GULP]

This sounds grim. This exodus of money will make stock markets crash. Cryptos that have been regarded as a hedge against the USD and the stock markets have actually proved to be highly correlated to the markets. I strongly believe that crypto currencies are the leading indicator of easy money in the market and they would collapse if all of what I said comes true.

So let’s Short everything?

Over confidence is the Achilles heel of a stock investor.

Regardless of your conviction in an idea, you should give yourself the chance to be wrong and live to fight another day.

Shorting is very dangerous and exiting the market completely may not be a great idea either.

For instance, when people are losing jobs, there would be a loss of confidence among real estate buyers and the banks to lend money to these buyers. In this case we might look at another slump in the real estate market despite lowered interest rates and money must stay in the stock markets.

If Trump wins election and cuts taxes this could also boost the stock market temporarily.

Staying invested and gradually buying the dip would still be the best way to navigate through these copy waters.