No one knows exactly what causes recessions, do they? This is one of the mantras we are taught in Macro 101. Every few years, a complex set of market inefficiencies will inevitably cause our ever-expanding economy to contract. And these market inefficiencies are so esoteric that even the most respected Nobel Prize-winning economists cannot predict a recession with any scientific certainty.
But the world we live in is nothing like the one we were taught in Macro 101. Gone are the mythical, complex and financially induced reasons for a recession. Instead, they’ve been replaced with a much simpler explanation. In fact, it’s so simple that anyone from the chairman of the Federal Reserve to an elementary school kid could tell you exactly what caused the recession in 2020: COVID-19. And not only that, but this recession was also the shortest on record – just two months. For context, the average recession between 1945 and 2008 lasted about 11 months, according to the National Bureau of Economic Research (NBER).
The pandemic has shaken the very foundation of macroeconomic theory: the business cycle. And that could have big consequences for investors. If we are in fact in a new round of expansion, investors can rest easy knowing that it will likely continue for at least a few years. Some institutional investors, such as the Florida State Board of Administration (SBA)), have taken this position.
However, if this theory proves to be wrong and the markets still have not corrected the financial inefficiencies that have simmered since June 2009, investors who do not hedge properly could suffer major consequences. In that sense, Sean Bill, director of investments for the Santa Clara Valley Transportation Authority (VTA), said his team was trying to prepare for a market downturn.
“Now that the Fed is now talking about cutting and getting it over with by June or July, I have to think it’s going to get a lot trickier,” he said.
Bill is particularly nervous about rising interest rates. “We fear that once the Fed and the ECB [European Central Bank], the Bank of Japan and the People’s Bank of China are stepping on the accelerator, it would be a threat to the markets, ”he said.
Santa Clara VTA has shifted its weight to certain asset classes to prepare for this new future. The fund reduced its holdings in fixed income because negative real yields weighed heavily on returns, according to Bill, and the team reallocated much of that money to hedge funds and private credit. Santa Clara VTA also owns 10% of traditional sustainable assets such as real estate and 5% of diversified real assets such as farmland, timber and minerals. The fund is also bullish on the cryptocurrency space.
“Some of our hedge funds are taking a relatively large position in Bitcoin, which we also see as another great hedge,” Bill said.
However, there is still some evidence to support the idea that we are in a new business cycle. Robert Barbera, an economist at Johns Hopkins University whose research focuses on the relationship between finance and macroeconomics, said this current economic expansion looks markedly different from the expansion we saw before the pandemic.
“The expansion we were in from 2010 to 2019 was really disappointing economic growth,” he said. “The unemployment rate was low, but the job growth was so low that no one could find a job.”
In 2021, the situation has been much better for the labor market, with resignation rates reaching an all-time high in September. For Barbera, this is proof of a healthy economy on the main street.
“I think government authorities have had spectacular success in 2020,” he said, referring to federal economic stimulus policies. Nonetheless, he cautions against caution when it comes to equity markets.
“The price we are paying for this success is that we have financial asset prices that are very difficult to reconcile,” he said. “To me, it looks like there is a valuation problem here. But the valuation problem will likely be resolved once we see gradual increases in interest rates. “
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Tags: bull market, economy, Florida SBA, Florida State Board of Administration, Robert Barbera, Santa Clara Valley Transportation Authority, Sean Bill, VTA